Reading Material Economics of International Trade

HIMACHAL PRADESH NATIONAL LAW UNIVERSITY,
SHIMLA
Semester-III
B.A./B.B.A. LL.B. (H) Paper Code: B.A./B.B.A__
Credit-04
SUBJECT: ECONOMICS-III
(Economics of International Trade)
Module-I:
Introduction to International Economics and Trade Theories
1.1 Economics and International Economics, Subject matter of Economics of
International Trade, Features and importance of International Trade - Inter-Regional
and International Trade.
1.2 Theory of Absolute Advantage,
1.3 Theory of Comparative Advantage
1.4 Theory of Opportunity Costs,
1.5 Theory of Heckscher-Ohlin Theory of Trade – Its main Features, Assumptions and
Limitations; Leontief Paradox.
Module-II
Terms of Trade, Tariff and Economic Integration
2.1 Terms of Trade: Concept, Measurement and Effects on Nation‘s Welfare.
2.2 Trade Policy: Arguments for and against Free Trade and Protection.
2.3 Tariff and Non-Tariff Barriers: Economic Effects.
2.4 Economic Integration: Concept and Forms of Regional Integration.
2.5 Static and Dynamic Effects of Custom Union.
Module-III
Balance of Payment and Foreign Exchange Rate
3.1 BOT, BOP, Current Account, Capital Account, Visible and Invisible, causes and
consequences of disequilibrium in Balance of Payments, Methods of correcting the
disequilibrium.
For Instructional Use, Private Circulation Only Page 1

3.2 Devaluation of Currency, Convertibility of Currency: Partial Account and Full
Account. Recent trends in balance of Payment in India.
3.3 Exchange Rate - Meaning - Demand and supply of Foreign Exchange; Types of
Exchange Rate: Fixed Vs Flexible Exchange Rate, Managed floating. Determination
of exchange rate in a free market.
3.4 Theories of Foreign Exchange Rate: Mint-Parity Theory
3.5 Purchasing Power Parity Theory, BoP Theory.
Module-IV
International Organisations
4.1 Objectives, Functions and Role of IMF, GATT and WTO
4.2 FDI and Portfolio Investment.
4.3 MNC‘s and regulation of MNC‘s, MNC‘S and India
4.4 Globalisation and its Consequences
4.5 Global Economic Crisis of 2007-09: USA and India
Text Books:
1. Rana, K.C. and K.N., Verma, International Economics, Vishal Publishing Company,
Jalandhar, Sixth Edition, 2016.
References:
1. Salvatore, Dominick, ‗International Economics‘, Weily India New Delhi (2008).
2. Mannur, H.G. ‗International Economics‘, Vikas Publishing House (1999)
3. C.P. Kindleberger ‗International Economics‘, R D Irwin, Homewood 8th Ed.
4. Bo Soderstein and Geoffrey Reed ‗International Economics‘ MacMillan (2005).
5. Francis Cherunilam - ‗International Economics‘ (2016)
6. Errol D‘Souza, ‗Macro Economics‘, Pearson Education 2008.
7. RBI bulletin, Various issues.

Economics of International Trade
Module-I
Introduction to International Economics and Trade Theories

1.1 Economics and International Economics, Subject matter of Economics of
International Trade, Features and importance of International Trade - Inter-
Regional and International Trade.
International trade is the exchange of goods and services as well as resources between
countries. It involves transactions between residents of different countries. As distinguished
from domestic trade or internal trade which involves exchange of goods and services within
the domestic territory of a country using domestic currency, international trade involves
transactions in multiple currencies. Compared to internal trade, international trade has
greater complexity as it involves heterogeneity of customers and currencies, differences in
legal systems, more elaborate documentation, diverse restrictions in the form of taxes,
regulations, duties, tariffs, quotas, trade barriers, standards, restraints to movement of
specified goods and services and issues related to shipping and transportation. At present,
liberal international trade is an integral part of international relations and has become an
important engine of growth in developed as well as developing countries. While some
economists and policy makers argue that there are net benefits from keeping markets open
to international trade and investments, others feel that3 trade generates a number of adverse
consequences on the welfare of citizens. We need to have an objective understanding of the
claims put forth by both sections. We shall first examine the arguments in support of
international trade.
(i) International trade is a powerful stimulus to economic efficiency and contributes to economic
growth and rising incomes. The wider market made possible owing to trade induces companies
to reap the quantitative and qualitative benefits of extended division of labour. As a result, they
would enlarge their manufacturing capabilities and benefit from economies of large scale
production. The gains from international trade are reinforced by the increased competition that
domestic producers are confronted with on account of globalization of production and marketing
requiring businesses to compete against global businesses. Competition from foreign goods

compels manufacturers, especially in developing countries, to enhance efficiency and
profitability by adoption of cost reducing technology and business practices.
Efficient deployment of productive resources to their best uses is a direct economic advantage of
foreign trade. Greater efficiency in the use of natural, human, industrial and financial resources
ensures productivity gains. Since international trade also tends to decrease the likelihood of
domestic monopolies, it is always beneficial to the community.
(ii) Trade provides access to new markets and new materials and enables sourcing of inputs and
components internationally at competitive prices. This reflects in innovative products at lower
prices and wider choice in products and services for consumers. Also, international trade enables
consumers to have access to wider variety of goods and services that would not otherwise be
available. It also enables nations to acquire foreign exchange reserves necessary for imports
which are crucial for sustaining their economies.
(iii) International trade enhances the extent of market and augments the scope for mechanization
and specialisation. Trade necessitates increased use of automation, supports technological
change, stimulates innovations, and facilitates greater investment in research and development
and productivity improvement in the economy.
(iv) Exports stimulate economic growth by creating jobs, which could potentially reduce poverty
and augmenting factor incomes and in so doing raising standards of livelihood and overall
demand for goods and services. Trade also provides greater stimulus to innovative services in
banking, insurance, logistics, consultancy services etc.
(v) Employment generating investments, including foreign direct investment, inevitably follow
trade. For emerging economies, improvement in the quality of output of goods and services,
superior products, finer labour and environmental standards etc. enhance the value of their
products and enable them to move up the global value chain.
(vi) Opening up of new markets results in broadening of productive base and facilitates export
diversification so that new production possibilities are opened up. Countries can gainfully
dispose off their surplus output and, thus, prevent undue fall in domestic prices caused by
overproduction. Trade also allows nations to maintain stability in prices and supply of goods
during periods of natural calamities like famine, flood, epidemic etc.
(vii) Trade can also contribute to human resource development, by facilitating fundamental and
applied research and exchange of know-how and best practices between trade partners.

(viii)Trade strengthens bonds between nations by bringing citizens of different countries together
in mutually beneficial exchanges and, thus, promotes harmony and cooperation among nations.
Despite being a dynamic force which has enormous potential to generate economic overall gains,
liberal global trade and investments are often criticized as detrimental to national interests.
The major arguments put forth against trade openness are:
(i) Possible negative labour market outcomes in terms of labour-saving technological change that
depress demand for unskilled workers, loss of labourers‘ bargaining power, downward pressure
on wages of semi skilled and unskilled workers and forced work under unfair circumstances and
unhealthy occupational environments.
(ii) International trade is often not equally beneficial to all nations. Potential unequal market
access and disregard for the principles of fair trading system may even amplify the differences
between trading countries, especially if they differ in their wealth. Economic exploitation is a
likely outcome when underprivileged countries become vulnerable to the growing political
power of corporations operating globally. The domestic entities can be easily outperformed by
financially stronger transnational companies.
(iii) International trade is often criticized for its excessive stress on exports and profit-driven
exhaustion of natural resources due to unsustainable production and consumption. Substantial
environmental damage and exhaustion of natural resources in a shorter span of time could have
serious negative consequences on the society at large.
(iv) Probable shift towards a consumer culture and change in patterns of demand in favour of
foreign goods which are likely to occur in less developed countries may have adverse effect on
the development of domestic industries and may even threaten the survival of infant industries.
Trade cycles and the associated economic crises occurring in different countries are also likely to
get transmitted rapidly to other countries.
(v) Risky dependence of underdeveloped countries on foreign nations impairs economic
autonomy and endangers their political sovereignty. Such reliance often leads to widespread
exploitation and loss of cultural identity. Substantial dependence may also have severe adverse
consequences in times of wars and other political disturbances.
(vi) Welfare of people may be ignored or jeopardized for the sake of profit. Excessive exports
may cause shortages of many commodities in the exporting countries and lead to high inflation

(e.g. onion price rise in 2014). Also, import of harmful products may cause health hazards and
environmental damage.(e.g. Chinese products).
(vii) Too much export orientation may distort actual investments away from the genuine
investment needs of a country.
(viii)Instead of cooperation among nations, trade may breed rivalry on account of severe
competition
(ix) Finally, there is often lack of transparency and predictability in respect of many aspects
related to trade policies of trading partners. There are also many risks in trade which are
associated with changes in governments‘ policies of participating countries, such as imposition
of an import ban or trade embargoes.
You might have noticed that many goods and services are imported by us because they are
simply not produced in our country for various reasons and therefore not available domestically.
However, we do import many things which can be produced or are being produced within our
country. Why do we do so? Is it beneficial to engage in international trade? The theories of
international trade which we discuss in the following sections provide answers to these and other
related questions.
Mercantilism, which was the policy of Europe‘s great powers, was based on the premise that
national wealth and power are best served by increasing exports and collecting precious metals in
return. Mercantilists also believed that the more gold and silver a country accumulates, the richer
it becomes. Mercantilism advocated maximizing exports in order to bring in more ―specie‖
(precious metals) and minimizing imports through the state imposing very high tariffs on foreign
goods. This view argues that trade is a ‗zero-sum game‘, with winners who win does so only at
the expense of losers and one country‘s gain is equal to another country‘s loss, so that the net
change in wealth or benefits among the participants is zero. The arguments put forth by
mercantilists were later proved to have many shortcomings by later economists. Although it is
still very important theory which explains policies followed by many big and fast growing
economies in Asia.
India‘s foreign trade was largely determined by the strategic needs of the British colonial powers
prior to its independence in 1947 like other colonies, India too was a supplier of raw materials
and agricultural commodities to Britain and other industrial countries and it used to import the
manufactured goods from Britain. The dependence of colonial India on Britain for manufactured

goods hindered the process of industrialization and obliterated the indigenous handicraft and
cottage industries. As a part of the British strategy, India had to export more than its imports
prior to World War II, so as to meet the unilateral transfer of payments to Britain by way of the
salaries and pensions of the British officers, both military and civil, dividends on British capital
invested in India, and interest on sterling loans. This helped India to achieve a favourable trade
balance. In April 1946, India was able to build a huge sterling balance of Rs. 17.33 billion, even
after paying of the sterling debt. However, the share of raw materials in India‘s exports declined
from 45 per cent in 1938-39 to 31 per cent in 1947-48 whereas the share of manufactured goods
increased from 30 per cent in 1938-39 to 49 per cent in 1947-48. It was only after independence
that India‘s trade patterns began to change in view of its developmental needs. India, as a newly
independent country, had to import equipment and machinery that could not be manufactured
domestically, in order to create new production capacity and build infrastructure, known as
developmental imports. Foreign Trade is the important factor in economic development in any
nation. Foreign trade in India comprises of all imports and exports to and from India. The
Ministry of Commerce and Industry at the level of Central Government has responsibility to
manage such operations. The domestic production reveals on exports and imports of the country.
The production consecutively depends on endowment of factor availability. This leads to relative
advantage of the financial system. Currently, International trade is a crucial part of development
strategy and it can be an effective mechanism of financial growth, job opportunities and poverty
reduction in an economy. According to Traditional Pattern of development, resources are
transferred from the agricultural to the manufacturing sector and then into services.
We live in a global marketplace. The food on your table might include fresh fruit from Chile,
cheese from France, and bottled water from Scotland. Your wireless phone might have been
made in Taiwan or Korea. The clothes you wear might be designed in Italy and manufactured in
China. The toys you give to a child might have come from India. The car you drive might come
from Japan, Germany, or Korea. The gasoline in the tank might be refined from crude oil from
Saudi Arabia, Mexico, or Nigeria. As a worker, if your job is involved with farming, machinery,
airplanes, cars, scientific instruments, or many other technology-related industries, the odds are
good that a hearty proportion of the sales of your employer and hence the money that pays your

salary comes from export sales. We are all linked by international trade, and the volume of that
trade has grown dramatically in the last few decades.
International economics refers to a study of international forces that influence the domestic
conditions of an economy and shape the economic relationship between countries. In other
words, it studies the economic interdependence between countries and its effects on economy.
The scope of international economics is wide as it includes various concepts, such as
globalization, gains from trade, pattern of trade, balance of payments, and FDI. Apart from this,
international economics describes production, trade, and investment between countries.
International economics has emerged as one of the most essential concepts for countries. Over
the years, the field of international economics has developed drastically with various theoretical,
empirical, and descriptive contributions.
Features of Foreign Trade of India are:

1. Negative or Unfavorable Trade
2. Diversity in Exports
3. Worldwide Trade
4. Change in Imports
5. Maritime Trade
6. Trade through a few Selected Ports Only
7. Insignificant Place of India in the World Overseas Trade
8. State Trading
1. Negative or Unfavorable Trade:
India had to import various items like heavy machinery, agricultural implements, mineral oil and
metals on a large scale after Independence for economic growth. But our exports could not keep
pace with our imports which left us with negative or unfavorable trade.
2. Diversity in Exports:
Previously, India used to export its traditional commodities only which included tea, jute, cotton
textile, leather, etc. But great diversity has been observed in India‘s export commodities during
the last few years. India now exports over 7,500 commodities. Since 1991, India has emerged as

a major exporter of computer software and that too to some of the advanced countries like the
USA and Japan.
3. Worldwide Trade:
India had trade links with Britain and a few selected countries only before Independence. But
now India has trade links with almost all the regions of the world. India exports its goods to as
many as 190 countries and imports from 140 countries.
4. Change in Imports:
Earlier we used to import food-grains and manufactured goods only. But now oil is the largest
single commodity imported by India. Both the imports as well as exports of pearls and precious
stones have increased considerably during the last few years. Our other important commodities
of import are iron and steel, fertilizers, edible oils and paper.
5. Maritime Trade:
About 95 per cent of our foreign trade is done through sea routes. Trade through land routes is
possible with neighboring countries only. But unfortunately, all our neighboring countries
including China, Nepal, and Myanmar are cut off from India by lofty mountain ranges which
makes trade by land routes rather difficult. We can have easy access through land routes with
Pakistan only but the trade suffered heavily due to political differences between the two
countries.
6. Trade through a few Selected Ports Only:

We have only 12 major ports along the coast of India which handle about 90 per cent overseas
trade of India. Very small amount of foreign trade is handled by the remaining medium and
small ports.
7. State Trading:
Most of India‘s overseas trade is done in public sector by state agencies and very little trade is
done by individuals

Difference between inter regional and international trade
Factor Immobility:
There is complete adjustment to wage differences and factor-price disparities within a country
with quick and easy movement of labour and other factors from low return to high sectors. But
no such movements are possible internationally. Price changes lead to movement of goods
between countries rather than factors. The reasons for international immobility of labour are
difference in languages, customs, occupational skills and unwillingness. The international
mobility of capital is restricted not by transport costs but by the difficulties of legal redress,
political uncertainty, ignorance of the prospects of investment in a foreign country, imperfections
of the banking system, instability of foreign currencies, mistrust of the foreigners, etc. Thus,
widespread legal and other restrictions exist in the movement of labour and capital between
countries. But such problems do not arise in the case of inter-regional trade.
2. Differences in Natural Resources:
Different countries are endowed with different types of natural resources. Hence they tend to
specialise in production of those commodities in which they are richly endowed and trade them
with others where such resources are scarce.
Example: In Australia, land is in abundance but labour and capital are relatively scarce. On the
contrary, capital is relatively abundant and cheap in England while land is scarce and dear there.
Thus, commodities requiring more capital, such as manufactures, can be produced in England;
while such commodities as wool, mutton, wheat, etc. requiring more land can be produced in
Australia. Thus both countries can trade each other‘s commodities on the basis of comparative
cost differences in the production of different commodities.
3. Geographical and Climatic Differences:
Every country cannot produce all the commodities due to geographical and climatic conditions,
except at possibly prohibitive costs. For instance, Brazil has favourable climate geographical
conditions for the production of coffee; Bangladesh for jute; Cuba for beet sugar; etc. So

countries having climatic and geographical advantages specialise in the production of particular
commodities and trade them with others.
4. Different Markets:
International markets are separated by difference in languages, usages, habits, tastes, fashions
etc. Even the systems of weights and measures and pattern and styles in machinery and
equipment differ from country to country. For instance, British railway engines and freight cars
are basically different from those in France or in the United States.
Thus goods which may be traded within regions may not be sold in other countries. That is why,
in great many cases, products to be sold in foreign countries are especially designed to confirm
to the national characteristics of that country. Similarly, in India right-hand driven cars are used
whereas in Europe and America left-hand driven cars are used.
5. Mobility of Goods:
There is also the difference in the mobility of goods between inter-regional and international
markets. The mobility of goods within a country is restricted by only geographical distances and
transportation costs. But there are many tariff and non-tariff barriers on the movement of goods
between countries. Besides export and import duties, there are quotas, VES, exchange controls,
export subsidies, dumping, etc. which restrict the mobility of goods at international plane.
6. Different Currencies:
The principal difference between inter-regional and international trade lids in use of different
currencies in foreign trade, but the same currency in domestic trade. Rupee is accepted
throughout India from the North to the South and from the East to the West, but if we cross over
to Nepal or Pakistan, we must convert our rupee into their rupee to buy goods and services there.
It is not the differences in currencies alone that are important in international trade, but changes
in their relative values. Every time a change occurs in the value of one currency in terms of
another, a number of economic problems arise. ―Calculation and execution of monetary

exchange transactions incidental to international trading constitute costs and risks of a kind that
are not ordinarily involved in domestic trade.‖
―It is this difference in policies rather than the existence of different national currencies which
distinguishes foreign trade from domestic trade,‖ Kindle berger.
7. Problem of Balance of Payments:
Another important point which distinguishes international trade from inter-regional trade is the
problem of balance of payments. The problem of balance of payments is perpetual in
international trade while regions within a country have no such problem. This is because there is
greater mobility of capital within regions than between countries. Further, the policies which a
country chooses to correct its disequilibrium in the balance of payments may give rise to a
number of other problems. If it adopts deflation or devaluation or restrictions on imports or the
movement of currency, they create further problems. But such problems do not arise in the case
of inter-regional trade.
8. Different Transport Costs:
Trade between countries involves high transport costs as against inter- regionally within a
country because of geographical distances between different countries.
9. Different Economic Environment:
Countries differ in their economic environment which affects their trade relations. The legal
framework, institutional set-up, monetary, fiscal and commercial policies, factor endowments,
production techniques, nature of products, etc. differ between countries. But there is no much
difference in the economic environment within a country.
10. Different Political Groups:
A significant distinction between inter-regional and international trade is that all regions within a
country belong to one political unit while different countries have different political units. Inter-
regional trade is among people belonging to the same country even though they may differ on the

basis of castes, creeds, religions, tastes or customs. They have a sense of belonging to one nation
and their loyalty to the region is secondary. But in international trade there is no cohesion among
nations and every country trades with other countries in its own interests and often to the
detriment of others.
As remarked by Friedrich List, “Domestic trade is among us, international trade is

between us and them.”
11. Different National Policies:
Another difference between inter-regional and international trade arises from the fact that
policies relating to commerce, trade, taxation, etc. are the same within a country. But in
international trade there are artificial barriers in the form of quotas, import duties, tariffs,
exchange controls, etc. on the movement of goods and services from one country to another.
Conclusion:
Therefore, the classical economists asserted on the basis of the above arguments that
international trade was fundamentally different from domestic or inter-regional trade. Hence,
they evolved a separate theory for international trade based on the principle of comparative cost
differences. Nevertheless, there are several reasons to believe the classical view that international
trade is fundamentally different from inter-regional trade.
Theory of Absolute Advantage
The theory of absolute advantage was put forward by Adam Smith who argued that different
countries enjoyed absolute advantage in the production of some goods which formed the basis of
trade between the countries.
Table 1.2: Man-Hours required to produce one unit of wheat and cloth
U.S.A India
Wheat 3 10
Cloth 6 4

It will be seen from the above table that to produce one unit of wheat in the U.S.A. 3 man-hours
and in India 10 man-hours are required. On the other hand, to produce one unit of cloth, in the
U.S.A. 6 man-hours and in India 4 man-hours are required. Thus the U.S.A. can produce wheat
more efficiently (that is, at a lower cost), while India can produce cloth more efficiently.
To put it in other words, while the U.S.A. has an absolute advantage in the production of wheat,
India has an absolute advantage in the production of cloth. Adam Smith showed that the two
countries would benefit and world output will increase if the two countries specialize in the
production of goods in which they have absolute advantage and trade with each other. How such
specialization and trade would lead to gain in output and would be mutually beneficial for the
two countries is shown in Table 1.3.
Table 1.3: Gain in Output when labour resources are transferred
U.S.A India World Output

Gain in Wheat +2 Wheat -1 Wheat +1 Wheat
Gain in Cloth -1 Cloth +2.5 Cloth +1.5 Cloth
Suppose to specialize in the production of Wheat, the U.S.A. withdraws 6 man-hours from the
production of cloth and devote them to the production of wheat, it will lose 1 unit of cloth and
gain 2 units of wheat.
Similarly, to specialize in the production of cloth if India withdraws 10 hours of labour from
wheat and use them for the production of cloth, it will lose one unit of wheat but gain 2.5 units of
cloth. In this way, transfer of labour resources to the goods in which they have absolute
advantage, will result I the net gain of one unit of wheat and 2.5 units of cloth. The gain in output
can be distributed between the two countries through voluntary exchange.
According to Adam Smith, who is regarded as the father of modern economics, countries should
only produce goods that they have an absolute advantage in. A country is said to have an
absolute advantage if the country can produce a good at a lower cost than another. Furthermore,
this means that fewer resources are needed to provide the same amount of goods as compared to

the other country. This efficiency in production creates ―an absolute advantage,‖ which allows
for beneficial trade.
Assumptions in Absolute Advantage
1. Lack of Mobility for Factors of Production
Adam Smith assumes that factors of production cannot move between countries.
This assumption also implies that the Production Possibility Frontier of each country will not
change after the trade.
2. Trade Barriers
There are no barriers to trade for the exchange of good. Governments implement trade barriers to
restrict or discourage the importation or exportation of a particular good.
3. Trade Balance
Smith assumes that exports must be equal to imports. This assumption means that we cannot
have trade imbalances, trade deficits or surpluses. A trade imbalance occurs when exports are
higher than imports or vice versa.
4. Constant Returns to Scale
Adam Smith assumes that we will get constant returns as production scales, meaning there are no
economies of scale. For example, if it takes 2 hours to make one loaf of bread in country A, then
it should take 4 hours to produce two loaves of bread. Consequently, it would take 8 hours to
produce four loaves of bread. However, if there were economies of scale, then it would become
cheaper for countries to keep producing the same good as it produced more of the same good.
The Theory of Comparative Advantage

David Ricardo developed the classical theory of comparative advantage in his book ‗Principles
of Political Economy and Taxation‘ published in 1817. The law of comparative advantage states
that even if one nation is less efficient than (has an absolute disadvantage with respect to) the

other nation in the production of all commodities, there is still scope for mutually beneficial
trade. The first nation should specialize in the production and export of the commodity in which
its absolute disadvantage is smaller (this is the commodity of its comparative advantage) and
import the commodity in which its absolute disadvantage is greater (this is the commodity of its
comparative disadvantage). Comparative advantage differences between nations are explained by
exogenous factors which could be due to the differences in national characteristics. Labour
differs in its productivity internationally and different goods have different labour requirements,
so comparative labor productivity advantage was Ricardo‘s predictor of trade.
The theory can be explained with a simple example given in table:
Country B has now absolute disadvantage in the production of both wheat and cloth. However,
since B‘s labour is only half as productive in cloth but six times less productive in wheat
compared to country A, country B has a comparative advantage in cloth. On the other hand,
country A has an absolute advantage in both wheat and cloth with respect to the country B, but
since its absolute advantage is greater in wheat (6:1) than in cloth (4:2), country A has a
comparative advantage in production and exporting wheat. In a two-nation, two-commodity
world, once it is established that one nation has a comparative advantage in one commodity, then
the other nation must necessarily have a comparative advantage in the other commodity. Put in
other words, country A‘s absolute advantage is greater in wheat, and so country A has a
comparative advantage in producing and exporting wheat. Country B‘s absolute disadvantage is
smaller in cloth, so its comparative advantage lies in cloth production. According to the law of
comparative advantage, both nations can gain if country A specialises in the production of wheat
and exports some of it in exchange for country B‘s cloth. Simultaneously, country B should
specialise in the production of cloth and export some of it in exchange for country A‘s wheat.

How do these two countries gain from trade by each country specializing in the production and
export of the commodity of its comparative advantage? We need to show that both nations can
gain from trade even if one of them (in this case country B) is less efficient than the other in the
production of both commodities.
Assume that country A could exchange 6W for 6C with country B. Then, country A would gain
2C (or save half an hour of labour time) since the country A could only exchange 6W for 4C
domestically. We need to show now that country B would also gain from trade. We can observe
from table that the 6W that the country B receives from the country A would require six hours of
labour time to produce in country B. With trade, country B can instead use these six hours to
produce 12C and give up only 6C for 6W from the country A. Thus, the country B would gain
6C or save three hours of labour time and country A would gain 2C. However, the gains of both
countries are not likely to be equal.
However, we need to recognize that this is not the only rate of exchange at which mutually
beneficial trade can take place. Country A would gain if it could exchange 6W for more than 4C
from country B; because 6W for 4 C is what it can exchange domestically (both require the same
one hour labour time). The more C it gets, the greater would be the gain from trade. Conversely,
in country B, 6W = 12C (in the sense that both require 6 hours to produce). Anything less than
12C that country B must give up to obtain 6W from country A represents a gain from trade for
country B. To summarize, country A gains to the extent that it can exchange 6W for more than
4C from the country B. country B gains to the extent that it can give up less than 12C for 6W
from country A. Thus, the range for mutually advantageous trade is 4C < 6W < 12C.
The spread between 12C and 4C (i.e., 8C) represents the total gains from trade available to be
shared by the two nations by trading 6W for 6C. The closer the rate of exchange is to 4C = 6W
(the domestic, or internal rate in country A), the smaller is the share of the gain going to country
A and the larger is the share of the gain going to country B. Alternatively, the closer the rate of
exchange is to 6W = 12C (the domestic or internal rate in country B), the greater is the gain of
country A relative to that of country B. However, if the absolute disadvantage that one nation has
with respect to another nation is the same in both commodities, there will be no comparative
advantage and no trade.
Ricardo based his law of comparative advantage on the ‗labour theory of value‘, which assumes
that the value or price of a commodity depends exclusively on the amount of labour going into

its production. This is quite unrealistic because labour is not the only factor of production, nor is
it used in the same fixed proportion in the production of all commodities.
In 1936, Haberler resolved this issue when he introduced the opportunity cost concept from
Microeconomic theory to explain the theory of comparative advantage in which no assumption is
made in respect of labour as the source of value. Opportunity cost is basically the value of the
forgone option. It is the ‘real‘ cost in microeconomic terms, as opposed to cost given in monetary
units.
According to the opportunity cost theory, the cost of a commodity is the amount of a second
commodity that must be given up to release just enough resources to produce one extra unit of
the first commodity. The opportunity cost of producing one unit of good X in terms of good Y
may be computed as the amount of labour required to produce one unit of good X divided by the
amount of labour required to produce one unit of good Y. That is, how much Y do we have to
give up in order to produce one more unit of good X. Logically, the nation with a lower
opportunity cost in the production of a commodity has a comparative advantage in that
commodity (and a comparative disadvantage in the second commodity).
In the above example, we find that country A must give up two-thirds of a unit of cloth to release
just enough resources to produce one additional unit of wheat domestically. Therefore, the
opportunity cost of wheat is two-thirds of a unit of cloth (i.e., 1W = 2/3C in country A).
Similarly, in country B, we find that 1W = 2C, and therefore, the opportunity cost of wheat (in
terms of the amount of cloth that must be given up) is lower in country A than in country B, and
country A would have a comparative (cost) advantage over country B in wheat. In a two-nation,
twocommodity world, if country A has a comparative advantage in wheat, then country B will
have a comparative advantage in cloth. Therefore, country A should consider specializing in
producing wheat and export some of it in exchange for cloth produced in country B. By such
specialization and trade, both nations will be able to consume more of both commodities than
what would have been possible
without trade.
In summary, international differences in relative factor-productivity are the cause of comparative
advantage and a country exports goods that it produces relatively efficiently. This points to a
tendency towards complete specialization in production. Ricardo demonstrated that for two
nations without input factor mobility, specialization and trade could result in increased total

output and lower costs than if each nation tried to produce in isolation. Trade generates welfare
gains and both countries can potentially gain from trade. Therefore, international trade need not
be a zero-sum game.
However, the Ricardian theory of comparative advantage suffers from many limitations. Its
emphasis is on supply conditions and excludes demand patterns. Moreover, the theory does not
examine why countries have different costs. The theory of comparative advantage also does not
answer the important question:
Why does a nation have comparative advantage in the production of a commodity and
comparative disadvantage in the production of another? The answer to this question is provided
by the Heckscher-Ohlin theory.
Criticisms

However, the principle of comparative advantage can be criticised in a several ways:
1. It may overstate the benefits of specialisation by ignoring a number of costs. These costs
include transport costs and any external costs associated with trade, such as air and sea
pollution.
2. The theory also assumes that markets are perfectly competitive - in particular, there is
perfect mobility of factors without any diminishing returns and with no transport costs.
The reality is likely to be very different, with output from factor inputs subject to
diminishing returns, and with transport costs. This will make the PPF for each country
non-linear and bowed outwards. If this is the case, complete specialisation might not
generate the level of benefits that would be derived from linear PPFs. In other words,
there is an increasing opportunity cost associated with increasing specialization
3. Complete specialisation might create structural unemployment as some workers cannot

transfer from one sector to another.
4. Relative prices and exchange rates are not taken into account in the simple theory of
comparative advantage. For example if the price of X rises relative to Y, the benefit of
increasing output of X increases.
5. Comparative advantage is not a static concept - it may change over time. For example,
nonrenewable resources can slowly run out, increasing the costs of production, and
reducing the gains from trade. Countries can develop new advantages, such as Vietnam
and coffee production. Despite having a long history of coffee production it is only in the
last 30 years that it has become a global player. seeing its global market share increase
from just 1% in 1985 to 20% in 2014, making it the world's second largest producer.
6. Many countries strive for food security, meaning that even if they should specialise in
non-food products, they still prefer to keep a minimum level of food production.

7. The principle of comparative advantage is derived from a highly simplistic two good/two
country model. The real world is far more complex, with countries exporting and
importing many different goods and services.
8. According to influential US economist Paul Krugman, the continual application of

economies of scale by global producers using new technology means that many
countries, including China, can produce very cheaply, and export surpluses. This, along
with an insatiable demand for choice and variety, means that countries typically produce
a variety of products for the global market, rather than specialise in a narrow range of
products, rendering the traditional theory of comparative advantage almost obsolete.
9. Modern approaches to explaining trade patterns and trade flows tend to use gravity theory
- which explains trade in terms of the positive attractiveness between two national
economies - based on economic size (in a similar fashion as planets attracting each other
based on their mass) - and the 'economic distance' between two economies. Economic
size attracts countries to trade, and economic distance makes trade harder. Economic
distance is increased by barriers to trade, and cultural, political and linguistic differences.
One advantage of gravity theory is that it can help economists predict the likely effect of
changes in government policy on trade patterns, including decisions regarding joining (or
leaving) trading blocs.
Theory of Opportunity Costs

‗If a given amount of factors of production [say a given combination of land, labour and
capital] can produce either one unit of commodity X or one unit of commodity Y, then the
opportunity cost of a unit of X is the sacrifice of one unit of Y.‘ Thus the rate of
exchange between commodities is expressed in terms of opportunity foregone of
producing, with the same combination of factors, units of another commodity.
Statement of Haberler‘s Theory of Opportunity Cost
If the country is not taking part in international trade, it will produce cloth and bread in
such a proportion that total welfare of the community is maximized. It is known that
consumer will do so by equalizing ratio of marginal utility of two commodities with ratio of their

marginal prices. Similarly, a producer maximizes his profits when the ratio of the prices
of products is equal to the ratio of their marginal costs.
Haberler‘s opportunity cost theory rests upon the following main assumptions:
1. The economic system is in a state of full employment equilibrium.
2. There is perfect competition in commodity and factor markets.
3. Price of each commodity equals the marginal cost of producing it.
4. Price of each factor equals its marginal productivity.
5. The supply of factors is fixed.
6. The state of technology is given.
7. There are two trading countries A and B.
8. Each country produces two commodities, say X and Y.
9. Each country has two productive factors- capital and labour.
On the basis of the above assumptions, it is possible to determine the opportunity cost curve or
the production possibility curve of any country. The production possibility curve indicates
different combinations of two commodities that a country can produce with the given factor
endowments and technology. The slope of the production possibility curve is determined by the
ratio of units of the commodity given up in order to have one unit of the other commodity. This
ratio is termed as a marginal rate of transformation (MRT). If two commodities X and Y are
being produced by a country and some quantities of labour, capital and other inputs are diverted
from the production of Y to the production of X, the additional production of X involves the
sacrifice of some quantity of Y. In other words, certain units of Y given up have been
transformed into the marginal unit of X. The rate at which marginal unit of X is being substituted
for certain units of Y is called the marginal rate of transformation.
Alternatively, the MRTxy can be defined as a ratio of the marginal cost of X to the marginal cost
of Y.
This can be derived as below:
Here δC stands for change in total cost,
δC/δX and δC/δY are the marginal costs of X and Y commodities respectively.
Assuming infinitesimally small changes in X and Y, δC will be equal to zero.
Since the MRTxy is negative, the opportunity cost curve or transformation curve slopes down
from left to right. The opportunity cost curve may be a straight line, convex to the origin or

concave to the origin, depending on whether return to scale in a country is constant, increasing or
decreasing respectively.
Theory of Heckscher-Ohlin Theory of Trade

The Heckscher-Ohlin (HO) model was developed by two Swedish economists EliHeckscher and
his student Bertil Ohlin. The Heckscher-Ohlin theory states that a country has a comparative
advantage in the good that is relatively intensive in the country‘s relatively abundant factor. The
HO model differs from the Ricardian model along two dimensions. Firstly, it adopts a more
realistic framework as compared to Ricardian model by allowing for a second factor of
production in the form of capital. Secondly, in the Heckscher-Ohlin model comparative
advantage is determined by differences in endowments of factors across countries instead of
differences in technology. In the Heckscher-Ohlin model countries have the same production
technologies.
Heckscher-Ohlin theory is known as modern theory of international trade. It was first formulated
by Swedish economist Heckscher in 1919 and later on fully developed by his student Ohlin in
1935. Heckscher-Ohlin theory, also called the factor endowments theory of international trade,
attempts to explain that international trade is simply a special case of inter-local or inter-regional
trade, and there is no need for a separate theory of international trade.
The following are the general features of the modern theory of international trade:
i. No Need for a Separate Theory:

According to the classical economists, international trade was basically different from
internal trade. Therefore, there is a need for a separate theory of international trade. The
difference between the international trade and internal trade arises due to various types of
differences between the countries, such as- (a) differences in efficiency in producing
different goods; (b) immobility of factors of production; (c) barriors caused by distance and
other physical factors; (d) use of different currencies; (e) existence of artificial barriers, such
as customs duties and other restrictions on trade; etc.
ii. A General Theory of Value:

Heckscher-Ohlin theory is considered as a general equilibrium theory of value at the
international level. According to the theory of value, at the equilibrium level, demand is
equal to supply and commodity price is equal to average cost of production.
Heckscher-Ohlin theory emphasises the mutual interdependence of the prices of
commodities, the prices of factors of production, the demand for commodities, and the
demand and supply of factors of production in international trade. Thus, while Marshall
explains the time- dimension of general theory of value, Heckscher-Ohlin theory explains the
space-dimension (i.e., international trade) of the general theory of value.
iii. Supplement to Ricardian Theory:

Heckscher-Ohlin theory supplements, and not supplants, the Ricardian comparative cost
theory of international trade. According to the Ricardian theory, the differences in the
comparative costs provide the foundation on which the international trade is possible. But, it
does not tell- why do the costs differ?
Ohlin‘s theory not only accepts the comparative advantage as the basis of international trade,
but also further develops the Ricardian theory by providing answer to the above question.
v. Factor Endowments Theory:
Heckscher-Ohlin theory is known as factor endowments theory or factor proportions theory
because it emphasises the interplay between the proportions in which different factors of
production are available in different countries, and the proportions in which they are used in
producing different goods. True basis of international trade is to be found in the comparative
advantage that emerges due to the difference in the factor endowments.
v. Statement of the Theory:

The Heckscher-Ohlin theory states that a country has a comparative advantage in the good
that is relatively intensive in the country‘s relatively abundant factor. The theory emphasises-
(a) that it is not merely the differences in costs (as the classical theory believes), but
differences in prices that become the basis of trade; (b) that the differences in costs are not
due to differences in factor efficiency, but due to the differences in the quantities of factors of
production; (c) that comparative advantage arises when abundant factor is utilised intensively
and scarce factor sparingly; and (d) that it is partial specialisation that will lead to the full

utilisation of factors of production, while complete specialisation will leave some quantities
of the factors of production unutilized.
vi. Pattern of Trade:

The Heckscher-Ohlin theory explains the pattern of world trade on the basis of differences in
factor endowments. In the labour-abundant countries, wages are likely to be low relative to
the cost of other factors of production. Cheap and abundant labour utilised in the production
of labour- intensive goods provides sufficient justification for exporting these goods to other
countries where labour is scarce and relative wages are higher. The same is true for other
factors of production.

SUMMARY
 International trade is the exchange of goods and services as well as resources between
countries and involves greater complexity compared to internal trade. Trade can be a
powerful stimulus to economic efficiency, contributes to economic growth and rising
incomes, enlarges manufacturing capabilities, ensures benefits from economies of large
scale production, and enhances competitiveness and profitability by adoption of cost
reducing technology and business practices.
 Efficient deployment of productive resources to their best uses, productivity gains,

decrease the likelihood of domestic monopolies, cost effective sourcing of inputs and
components internationally, innovative products at lower prices, wider choice in products
and services for consumers are also claimed as benefits of trade.
 Enhanced foreign exchange reserves, increased scope for mechanization and

specialisation, research and development, creation of jobs, reduction in poverty
,augmenting factor incomes, raising standards of livelihood ,increase in overall demand
for goods and services and greater stimulus to innovative services are other benefits.
 There are also other possible positive outcomes in the form of prospects of employment
generating investments, improvement in the quality of output, superior products, labour
and environmental standards, broadening of productive base, export diversification,
stability in prices and supply of goods, human resource development and strengthening of
bonds between nations.

 The arguments against trade converge on negative labour market outcomes, economic
exploitation, profit-driven exhaustion of natural resources, shift towards a consumer
culture, risky dependence, shortages resulting in inflation, disregard for welfare of
people, quick transmission of trade cycles, rivalries and risks in trade associated with
changes in governments‘ policies of participating countries. Mercantilism advocated
maximizing exports in order to bring in more precious metals and minimizing imports
through the state imposing very high tariffs on foreign goods.
 According to Adam Smith‘s Absolute Cost Advantage theory,a country will specialize in
the production and export of a commodity in which it has an absolute cost advantage.
 Ricardo's theory of comparative advantage states that a nation should specialize in the
production and export of the commodity in which its absolute disadvantage is smaller
(this is the commodity of its comparative advantage) and import the commodity in which
its absolute disadvantage is greater (this is the commodity of its comparative
disadvantage).
 Haberler resolved the issue of dependence on labour alone in the case of theory of
comparative advantage when he introduced the opportunity cost concept. Opportunity
cost which is the value of the forgone option.
 The Heckscher-Ohlin theory of trade, also referred to as Factor-Endowment Theory of

Trade or Modern Theory of Trade, states that comparative advantage in cost of
production is explained exclusively by the differences in factor endowments.

 A country tends to specialize in the export of a commodity whose production requires
intensive use of its abundant resources and imports a commodity whose production
requires intensive use of its scarce resources. Accordingly, a capital abundant country
will produce and export capital-intensive goods relatively more cheaply and a labour-
abundant country will produce and export labour-intensive goods relatively more cheaply
than another country.
 Even when a country has high levels of productivity in all goods, it can still benefit from
trade. Gains from trade come about as a result of comparative advantage. By specializing
in a good that it gives up the least to produce, a country can produce more and offer that
additional output for sale. If other countries specialize in the area of their comparative
advantage as well and trade, the highly productive country is able to benefit from a lower
opportunity cost of production in other countries.
 A country has an absolute advantage in those products in which it has a productivity edge
over other countries; it takes fewer resources to produce a product. A country has a
comparative advantage when a good can be produced at a lower cost in terms of other
goods. Countries that specialize based on comparative advantage gain from trade.
Until recently, and to some extent even now, the United States has been a special case among
countries. Until a few years ago, the United States was much wealthier than other countries, and
U.S. workers visibly worked with more capital per person than their counterparts in other
countries. Even now, although some Western European countries and Japan have caught up, the
United States continues to be high on the scale of countries as ranked by capital-labor ratios.
One would then expect the United States to be an exporter of capital-intensive goods and an
importer of labor-intensive goods. Surprisingly, however, this was not the case in the 25 years
after World War II. In a famous study published in 1953, economist Wassily Leontief (winner of
the Nobel Prize in 1973) found that U.S. exports were less capital-intensive than U.S. imports.
This result is known as the Leontief paradox

Factor Content of U.S. Exports and Imports for 1962
Above table illustrates the Leontief paradox as well as other information about U.S. trade
patterns. We compare the factors of production used to produce $1 million worth of 1962 U.S.
exports with those used to produce the same value of 1962 U.S. imports. As the first two lines in
the table show, Leontief‘s paradox was still present in that year: U.S. exports were produced with
a lower ratio of capital to labor than U.S. imports. As the rest of the table shows, however, other
comparisons of imports and exports are more in line with what one might expect. The United
States exported products that were more skilled-labor-intensive than its imports, as measured by
average years of education. We also tended to export products that were ―technology-intensive,‖
requiring more scientists and engineers per unit of sales. These observations are consistent with
the position of the United States as a high-skill country, with a comparative advantage in
sophisticated products.
Why, then, do we observe the Leontief paradox?
In the same study, Leontief tried to rationalize his results rather than reject the H–O model. He
argued that what we had here was an optical illusion: Since in 1947 U.S. labor was about three
times as productive as foreign labor, the United States was really an L-abundant nation if we
multiplied the U.S. labor force by 3 and compared this figure to the availability of capital in the
nation. Therefore, it was only appropriate that U.S. exports should be L intensive in relation to
U.S. import substitutes. This explanation is not acceptable, and Leontief himself subsequently
withdrew it. The reason is that while U.S. labor was definitely more productive than foreign
labor (though the multiple of 3 used by Leontief was largely arbitrary), so was U.S. capital.

Therefore, both U.S. labor and U.S. capital should be multiplied by a similar multiple, leaving
the relative abundance of capital in the United States more or less unaffected.
Some studies have argued that this paradox was specific to the time period considered. Others
point to the needed assumption of common technologies used by the United States and its trading
partners, which is likely to be violated. One such violation that would explain the paradox goes
as follows: The United States has a special advantage in producing new products or goods made
with innovative technologies, such as aircraft and sophisticated computer chips. Such products
may well be less capital-intensive than products whose technology has had time to mature and
become suitable for mass production techniques. Thus the United States may be exporting goods
that heavily use skilled labor and innovative entrepreneurship, while importing heavy
manufactures (such as automobiles) that use large amounts of capital. Another explanation to the
Leontief‘s paradox has been given by Erik Hoff Meyer. He argues that if products relying to a
large extent on natural resources are excluded from Leontief‘s list of goods, the normally
expected picture that the U.S. exports capital intensive goods and imports labour intensive goods
will prevail. This being more general source of bias as Leontief used a two-factor model (L and
K), thus abstracting from other factors such as natural resources (soil, climate, mineral deposits,
forests, etc.). However, a commodity might be intensive in natural resources so that classifying it
as either K or L intensive (with a two-factor model) would clearly be inappropriate. Furthermore,
many production processes using natural resources—such as coal mining, steel production, and
farming—also require large amounts of physical capital. The U.S. dependence on imports of
many natural resources, therefore, might help explain the large capital intensity of U.S. import-
competing industries.
U.S. tariff policy was another source of bias in the Leontief study. A tariff is nothing else than a
tax on imports. As such, it reduces imports and stimulates the domestic production of import
substitutes. In a 1956 study, Kravis found that the most heavily protected industries in the United
States were the L-intensive industries. This biased the pattern of trade and reduced the labor
intensity of U.S. import substitutes, thus contributing to the existence of the Leontief paradox
Perhaps the most important source of bias was the fact that Leontief included in his measure of
capital only physical capital (such as machinery, other equipment, buildings, and so on) and
completely ignored human capital. Human capital refers to the education, job training, and health
embodied in workers, which increase their productivity. The implication is that since U.S. labor

embodies more human capital than foreign labor, adding the human capital component to
physical capital would make U.S. exports more K intensive relative to U.S. import substitutes.
(In fairness to Leontief, it must be said that the analysis of human capital became fully developed
and fashionable only following the work of Schultz in 1961 and Becker in 1964.).
Somewhat related to human capital is the influence of research and development (R&D) on U.S.
exports. The ―knowledge‖ capital resulting from R&D leads to an increase in the value of output
derived from a given stock of material and human resources. Even casual observation shows that
most U.S. exports are R&D and skill intensive. Thus, human and knowledge capital are
important considerations in determining the pattern of U.S. trade. These were not considered by
Leontief in his study. The most important of the numerous empirical studies following a human
capital approach were undertaken by Kravis, Keesing, Kenen, and Baldwin. In two studies
published in 1956, Kravis found that wages in U.S. exports industries in both 1947 and 1951
were about 15 percent higher than wages in U.S. import-competing industries. Kravis correctly
argued that the higher wages in U.S. exports industries were a reflection of the greater
productivity and human capital embodied in U.S. exports than in U.S. import substitutes.
In a 1966 study, Keesing found that U.S. exports were more skill intensive than the
exports of nine other industrial nations for the year 1957. This reflected the fact that the
United States had the most highly trained labor force, embodying more human capital than
other nations.
It remained for Kenen, in a 1965 study, to actually estimate the human capital embodied in U.S.
exports and import-competing goods, add these estimates to the physical capital requirements,
and then recompute K/L for U.S. exports and U.S. import substitutes. Using 1947 data and
without excluding products with an important natural resource content (as in the original
Leontief study), Kenen succeeded in eliminating the Leontief paradox.
In a 1971 study, Baldwin updated Leontief‘s study by using the 1958 U.S. input–output table and
U.S. trade data for 1962. Baldwin found that excluding natural resource industries was not
sufficient to eliminate the paradox unless human capital was included. The paradox remained,
however, for developing nations and for Canada. Similar paradoxical results arose by using other
countries‘ data. A 1977 study by Branson and Monoyios also raised some questions on the
appropriateness of combining human and physical capital into a single measure for the purpose
of testing the H–O trade model.

In 1980 and 1984 publications, Leamer argued that in a multifactor world we should compare the
K/L ratio in production versus consumption rather than in exports versus imports. Taking this
approach to Leontief‘s 1947 data, Leamer (1984) found that the K/L ratio embodied in U.S.
production was indeed greater than that embodied in U.S. consumption, so that the paradox
disappeared. This was confirmed in a 1981 study by Stern and Maskus for the year 1972 and in a
1990 study by Salvatore and Barazesh for each year from 1958 to 1981 when natural resource
industries were excluded.
In a 1987 study, however, Bowen, Leamer, and Sveikauskas, using more complete 1967 cross-
sectional data on trade, factor-input requirements, and factor endowments for 27 countries, 12
factors (resources), and many commodities, found that the H–O trade model was supported only
about half of the time. This seemed to inflict a devastating blow on the validity of the H–O
model. Subsequent research, however, does provide support for some restricted form of the H–O
trade model. In a 1993 study, Brecher and Choudhri found production evidence in support of the
H–O model for U.S.–Canadian trade; a 1994 study by Wood provided support for the H–O
model for trade between developed and developing countries based on differences in their
relative availability of skills and land, and so did a 1995 study by the World Bank.
Module 2
Terms of Trade, Tariff and Economic Integration
The terms of trade refer to the rate at which the goods of one country exchange for the goods of
another country. It is a measure of the purchasing power of exports of a country in terms of its
imports, and is expressed as the relation between export prices and import prices of its goods.
When the export prices of a country rise relatively to its imports prices, its terms of trade are said
to have improved. The country gains from trade because it can have a larger quantity of imports
in exchange for a given quantity of exports. On the other hand, when its imports prices rise
relatively to its export prices, its terms of trade are said to have worsened. The country‘s gains
from trade is reduced because it can have a smaller quantity of imports in exchange for a given
quantity of exports than before.
2.1 Terms of Trade: Concept, Measurement and Effects on Nation‘s Welfare

The different economists have given different concepts of terms of trade. These several concepts,
according to G. M. Meir fall into three categories: "(i) those that relate to ratio of exchange
between commodities - the commodity and income terms of trade (ii) those that relate to
interchange between productive resources the single and double factoral terms of trade and (iii)
those that interpret the gains from trade in terms of utility analysis - the real cost and utility terms
trade" (Meir, Gerald. M.; 1980).
Concepts of Terms of Trade:
The different economists have given different conceptions of terms of trade. Meir, Gerald. M
has classified the various concepts concerning the terms of trade into three broad categories:
1. On the basis of ratio of international exchange between commodities:
a. Net Barter terms of trade
The concept of net barter terms of trade was introduced by F. W. Taussig (1927). Jacob
Viner called it as commodity terms of trade (1995). It is defined as the ratio of export
prices to import prices. This ratio is usually multiplied by 100 in order to express the
terms of trade in percentages. The commodity or net barter terms of trade can be
expressed as: N=^xlOO Pm Where, N = Commodity or net barter terms of trade Px = export
price Pm= Import Price.
The concept of net barter or commodity terms of trade has been used by economists to
measure the gain from international trade. But this concept has important limitations. It
uses index number of export and import prices and the usual problems associated
with index number in terms of coverage base year and method of calculation arise. It does
not take into account the impact of factors and imports changes in quality of exports and
imports, changes in composition of trade, changes in productivity of export industries and
unilateral payments. It can sometime result in misleading conclusion. For example, if the
export price index of a country falls while the import price index remains the same,
the country is said to better from a deteriorating commodity terms of trade and declining
welfare. But if the fall in the country's prices of exports is the result of
improvement in its productive efficiency and the resultant fall in the cost of production,
the country will not be worse off than before; it will rather gain.
b. Gross barter terms of trade
c. Income terms of trade

2. On the basis of changes in factor productivity:
a. Single factoral terms of trade
b. Double factoral terms of trade
3. On the basis of utility analysis
a. Real cost terms of trade
b. Utility terms of trade
COMMODITY OR NET BARTER TERMS OF TRADE

The commodity or net barter terms of trade is the ratio between the price of a country‘s export
goods and import goods. Symbolically, it can be expressed as
Tc = Px/Pm
where Tc stands for the commodity terms of trade, P for price, the subscript x for exports and m
for imports. To measure changes in the commodity terms of trade over a period, the ratio of the
change in export prices to the change in import prices is taken. Then the formula for the
commodity terms of trade is
where the subscripts 0 and 1 indicate the base and end periods. Taking 1971 as the base year and
expressing India‘s both export prices and import prices as 100, if we find that by the end of 1981
its index of export prices had fallen to 90 and the index of import prices had risen to 110. The
terms of trade had changed as follows :
It implies that India‘s terms of trade declined by about 18 per cent in 1981 as compared with
1971, thereby showing worsening of its terms of trade. If the index of export prices had risen to

180 and that of import prices to 150, then the terms of trade would be 120. This implies an
improvement in the terms of trade by 20 per cent in 1981 over 1971.
The concept of the commodity or net barter terms of trade has been used by economists to
measure the gain from international trade. The terms of trade, as determined by the offer curves
in the Mill-Marshall analysis, are related to the commodity terms of trade.
ITS LIMITATIONS
Despite its use as a device for measuring the direction of movement of the gains from trade, this
concept has important limitations.
1. Problems of Index Numbers. Usual problems associated with index number in terms of
coverage, base year and method of calculation arise.
2. Change in Quality of Product. The commodity terms of trade are based on the index numbers
of export and import prices. But they do not take into account changes taking place in the quality
and composition of goods entering into trade between two countries. At best, a commodity terms
of trade index shows changes in the relative prices of goods exported and imported in the base
year. Thus the net barter terms of trade fail to account for large change in the quality of goods
that are taking place in the world, as also new goods that are constantly entering in international
trade.
3. Problem of Selection of Period. Problem arises in selecting the period over which the terms of
trade are studied and compared. If the period is too short, no meaningful change may be found
between the base date and the present. On the other hand, if the period is too long, the structure
of the country‘s trade might have changed and the export and import commodity content may not
be comparable between the two dates.
4. Causes of Changes in Prices. Another serious difficulty in the commodity terms of trade is that
it simply shows changes in export and import prices and not how such prices change. As a matter
of fact, there is much qualitative difference when a change in the commodity terms of trade
index is caused by a change in export prices relative to import prices as a result of changes in
demand for exports abroad, and ways or productivity at home. For instance, the commodity
terms of trade index may change by a rise in export prices relative to import prices due to strong
demand for exports abroad and wage inflation at home. The commodity terms of trade index
does not take into account the effects of such factors.

5. Neglect of Import Capacity. The concept of the commodity terms of trade throws no light on
the ―capacity to import‖ of a country. Suppose there is a fall in the commodity terms of trade in
India. It means that a given quantity of Indian exports will buy a smaller quantity of imports than
before. Along with this trend, the volume of Indian exports also rises, may be as a consequence
of the fall in the prices of exports. Operating simultaneously, these two trends may keep India‘s
capacity to import unchanged or even improve it. Thus the commodity terms of trade fails to take
into account a country‘s capacity to import.
6. Ignores Productive Capacity. The commodity terms of trade also ignores a change in the
productive efficiency of a country. Suppose the productive efficiency of a country increases. It
will lead to a fall in the cost of production and in the prices of its export goods. The fall in the
prices of export goods will be reflected in the worsening of its commodity terms of trade. But, in
reality, the country will not be worse off than before. Even though a given value of exports will
exchange for less imports, the country will be better off. This is because a given volume of
exports can now be produced with lesser resources, and the real cost of imports, in terms of
resources used in exports, remains unchanged.
7. Not Helpful in Balance of Payment Disequilibrium. The concept of commodity terms of trade
is valid if the balance of payments of a country includes only the export and imports of goods
and services, and the balance of payments balances in the base and the given years. If the balance
of payments also includes unilateral payments or unrequired exports and or/imports, such as
gifts, remittances from and to the other country, etc., leading to disequilibrium in the balance of
payments, the commodity terms of trade is not helpful in measuring the gains from trade.
8. Ignores Gains from Trade. The concept of commodity terms of trade fails to explain the
distribution of gains from trade between a developed and under-developed country. If the export
price index of an underdeveloped country rises more than its import price index, it means an
improvement in its terms of trade. But if there is an equivalent rise in profits of foreign
investments, there may not be any gain from trade. To overcome this last difficulty, Taussig
introduced the concept of the gross barter terms of trade.
GROSS BARTER TERMS OF TRADE
The gross barter terms of trade is the ratio between the quantities of a country‘s imports and
exports. Symbolically, Tg = Qm/Qx, where Tg stands for the gross terms of trade, Qm for
quantities of Imports and Qx for quantities of exports. The higher the ratio between quantities of

imports and exports, the better the gross terms of trade. A larger quantity of imports can be had
for the same volume of exports. To measure changes in the gross barter terms of trade over a
period, the index number of the quantities of imports and exports in base period and the end
period are related to each other. The formula for this is :
Taking 1971 as the base year and expressing India‘s both quantities of imports and exports as
100, if we find that the index of quantity imports had risen to 160 and that of quantity exports to
120 in 1981, then the gross barter of trade had changed as follows:
It implies that there was an improvement in the gross barter terms of trade of India by 33 per cent
in 1981 as compared with 1971. If the quantity of import index had risen by 130 and that of
quantity exports by 180, then the gross barter terms of trade would be 72.22.
This implies deterioration in the terms of trade by 18 per cent in 1981 over 1971. When the net
barter terms of trade (Tc) equal the gross barter terms of trade (Tg), the country has balance of
trade equilibrium. It shows that total receipts from exports of goods equal total payments for
import goods.
Numerically:

ITS CRITICISMS
The concept of gross barter terms of trade has been criticised by economists on the following
grounds:
1. Aggregating Goods, Services and Capital Transactions.
The concept of gross barter terms of trade has been criticised for lumping together all types of
goods and capital payments and receipts as one category in the index numbers of exports and
imports. No units are applicable equally to rice and to steel, or to export (or import) of capital
and the payment (or receipt) of a grant. It is therefore, not possible to distinguish between the
various types of transactions which are lumped together in the index. Haberler, Viner and other
economists have, therefore, dismissed this concept as unreal and impracticable as a statistical
measure.
2. Ignores Factor Productivity. This concept ignores the effect of improvement in factor
productivity on the terms of trade of a country. A country may have unfavourable gross barter
terms of trade due to increase in factor productivity
productivity in the export sector. This increased factor productivity, in turn, reflects the gain for
the exporting country.
3. Neglects Balance of Payments. The concept of gross barter terms of trade relates to the trade
balance and ignores the influence of international capital receipts and payments of a trading
country.
4. Ignores Improvements in Production. This concept measures the terms of trade in terms of
physical quantities of exports and imports but ignores qualitative improvements in the production
of exportable and importable goods.
5. Not True Index of Welfare. An improvement in gross barter terms of trade is regarded as an
index of a higher level of welfare from trade. For the country exchanges more importable goods
for its exportable goods. But this may not be true if tastes, preferences and habits of the people
change so that the country needs less importables which yield greater satisfaction to the people.
It will lead to unfavourable gross barter terms of trade but improve welfare.
Conclusion. Due to the above noted limitations, Viner uses only the concept of net barter terms
of trade while other writers use only the export-import price ratio as the commodity terms of
trade. So this concept has been discarded by economists.

2. INCOME TERMS OF TRADE Dorrance has improved upon the concept of the net
barter terms of trade by formulating the concept of the income terms of trade. This index
takes into account the volume of exports of a country and its export and import prices
(the net barter terms of trade). It shows a country‘s changing import capacity in relation
to changes in its exports. Thus, the income terms of trade is the net barter terms of trade
of a country multiplied by its export volume index. It can be expressed as : Ti = Tc. Qx =
(Px/Pm) * Qx
where Ty is the income terms of trade, Tc the commodity terms of trade and Qx the export
volume index.
where Ty is the income terms of trade, Tc the commodity terms of trade and Qx the export
volume index.
A.H. Imlah calculates this index by dividing the index of the value of exports by an index of the
price of imports. He calls it the ―Export Gain from Trade Index.‖
Taking 1971 as the base year, if Px = 140, Pm = 70 and Qx = 80 in 1981, then
It implies that there is improvement in the income terms of trade by 60 per cent in 1981 as
compared with 1971. If in 1981, Px = 80, Pm = 160 and Qx = 120,
then,
It implies that the income terms of trade have deteriorated by 40 per cent in 1981 as compared
with 1971. A rise in the index of income terms of trade implies that a country can import more
goods in exchange for its exports. A country‘s income terms of trade may improve but its
commodity terms of trade may deteriorate. Taking the import prices to be constant, if export
prices fall, there will be an increase in the sales and value of exports. Thus while the income

terms of trade might have improved, the commodity terms of trade might have deteriorated. The
income terms of trade is called the capacity to import. In the long-run, the total value of exports
of a country must equal to its total value of imports, i.e., Px.Qx = Pm.Qm or Px.Qx/Pm = Qm.
Thus Px.Qx/Pm determines Qm which is the total volume that a country can import. The
capacity to import of a country may increase if other things remain the same (i) the price of
exports (Px) rises, or (ii) the price of imports (Pm) falls, or (iii) the volume of its exports (Qx)
rises. Thus the concept of the income terms of trade is of much practical value for developing
countries having low capacity to import.
ITS CRITICISMS
The concept of income terms of trade has been criticised on the following counts:
1. Fails to Measure Gain or Loss from Trade.
The index of income terms of trade fails to measure precisely the gain or loss from international
trade. When the capacity to import of a country increases, it simply means that it is also
exporting more than before. In fact, exports include the real resources of a country which can be
used domestically to improve the living standard of its people.
2. Not Related to Total Capacity to Import. The income terms of trade index is related to the
export based capacity to import and not to the total capacity to import of a country which
also includes its foreign exchange receipts. For example, if the income terms of trade index
of a country has deteriorated but its foreign exchange receipts have risen, its capacity to
import has actually increased, even though the index shows deterioration.
3. Inferior to Commodity Terms of Trade. Since the index of income terms of trade is based on
commodity terms of trade and leads to contradictory results, the concept of the commodity
terms of trade is usually used in preference to the income terms of trade concept for
measuring the gain from international trade.
4. SINGLE FACTORAL TERMS OF TRADE The concept of commodity terms of trade does
not take account of productivity changes in export industries. Prof. Viner had developed the
concept of single factoral terms of trade which allows changes in the domestic export sector.
It is calculated by multiplying the commodity terms of trade index by an index of
productivity changes in domestic export industries. It can be expressed as :

where Ts is the single factoral terms of trade, Tc is the commodity terms of trade, and Fx is
the productivity index of export industries. It shows that a country‘s factoral terms of trade
improve as productivity improves in its export industries. If the productivity of a country‘s
exports industries increases, its factoral terms of trade may improve even though its
commodity terms of trade may deteriorate. For example, the prices of its exports may fall
relatively to its import prices as a result of increase in the productivity of the export
industries of a country. The commodity terms of trade will deteriorate but its factoral terms
of trade will show an improvement. Its Limitations. This index is not free from certain
limitations. It is difficult to obtain the necessary data to compute a productivity index.
Further, the single factoral terms of trade do not take into account the potential domestic cost
of production of imports industries in the other country. To overcome this weakness, Viner
formulated the double factoral terms of trade.
DOUBLE FACTORAL TERMS OF TRADE
The double factoral terms of trade take into account productivity changes both in the
domestic export sector and the foreign export sector producing the country‘s imports. The
index measuring the double factoral terms of trade can be expressed as :
where Td is the double factoral terms of trade, Px/Pm is the commodity terms of trade, Fx is
the export productivity index, and Fm is the import productivity index. It helps in measuring
the change in the rate of exchange of a country as a result of the change in the productive
efficiency of domestic factors manufacturing exports and that of foreign factors
manufacturing imports for that country. A rise in the index of double factoral terms of trade
of a country means that the productive efficiency of the factors producing exports has
increased relatively to the factors producing imports in the other country.
Its Criticisms

1. Not Possible to Construct a Double Factoral Terms of Trade Index.
In practice, however, it is not possible to calculate an index of double factoral terms of trade
of a country. Prof. Devons made some calculations of changes in the single factoral terms of
trade of England between 1948-53. But it has not been possible to construct a double
factoral terms of trade index of any country because it involves measuring and comparing
productivity changes in the import industries of the other country with that of the domestic
export industries.
2. Required Quantity of Productive Factors not Important. Moreover, the important
thing is the quantity of commodities that can be imported with a given quantity of exports
rather than the quantity of productive factors required in a foreign country to produce its
imports.
3. No Difference Between the Double Factoral Terms of Trade and the Commodity
Terms of Trade. Again, if there are constant returns to scale in manufacturing and no
transport costs are involved, there is no difference between the double factoral terms of trade
and the commodity terms of trade of a country.
4. Single Factoral Terms of Trade is more Relevant Concept. According to Kindleberger,
―The single factoral terms of trade is a much more relevant concept than the double factoral.
We are interested in what our factor can earn in goods, not what factor services can
command in the services of foreign factors. Related to productivity abroad moreover, is a
question of the quality of the goods imported.‖
REAL COST TERMS OF TRADE
Viner has also developed a terms of trade index to measure the real gain from international
trade. He calls it the real cost terms to trade index. This index is calculated by multiplying
the single factoral terms of trade with the reciprocal of an index of the amount of disutility
per unit of productive resources used in producing export commodities. It can be expressed
as:

where Tr is the real cost terms of trade, Ts is the single factoral terms of trade and Rx is the
index of the amount of disutility per unit of productive resources used in producing export
commodities.
ITS CRITICISMS
A favourable real cost terms of trade index (Tr) shows that the amount of imports received
is greater in terms of the real cost involved in producing export commodities. But this index
fails to measure the real cost involved in the form of goods produced for export which could
be used for domestic consumption to pay for imports. To overcome this problem. Viner
develops the index of utility terms of trade.
UTILITY TERMS OF TRADE

The utility terms of trade index measures ―changes in the disutility of producing a unit of
exports and changes in the relative satisfactions yielded by imports, and the domestic
products foregone as the result of export production.‖ In other words, it is an index of the
relative utility of imports and domestic commodities forgone to produce exports. The utility
terms of trade index is calculated by multiplying the real cost terms of trade index with an
index of the relative average utility of imports and of domestic commodities foregone. If we
denote the average utility by u and the domestic commodities whose consumption is
foregone to use resources for export production by a, then
where u is the index of relative utility of imports and domestically foregone commodities.
Thus, the utility terms of trade index can be expressed as :
Since the real terms of trade index and utility terms of trade index involve the measurement
of disutility in terms of pain, irksomeness and sacrifice, they are elusive concepts. As a
matter of fact, it is not possible to measure disutility (for utility) in concrete terms.
Its Criticisms

Hence like the single and double factoral terms of trade concepts, the concepts of real and
utility terms of trade are of little practical use. They are only of academic interest. That is
why the concepts of the commodity terms of trade and of income terms of trade have been
used in measuring the gains from international trade in developed as well as developing
countries.
1. FREE TRADE MEANING Free trade policy refers to a trade policy without any
tariffs, quantitative restrictions and other devices obstructing the movement of goods
between countries. Prof. Jagdish Bhagwati defines free trade policy, ―as absence of
tariffs, quotas, exchange restrictions, taxes and subsidies on production, factor use and
consumption‖.1 This is an exhaustive definition. Prof. Lipsey gives a very simple
definition. According to him, ―A world of FREE TRADE would be one with no tariffs
and no restrictions of any kind on importing or exporting. In such a world, a country
would import all those commodities that it could buy from abroad at a delivered price
lower than the cost of producing them at home.‖ Thus the policy of free trade means
simply complete freedom of international trade without any restrictions on the movement
of goods between countries. However, there is an exception. Import duties can be levied
for revenue and not for protection even under free trade.This can be understood with the
help of an example. If the government levies a duty of 15 per cent on all imports, all
foreign goods which enjoy a cost and trade will continue as usual. But if even a simple
foreign good enjoys a cost advantage of less than 15 per cent, it means the end free trade
and import duty is for protection and not for revenue alone. Thus a country following the
free trade policy levies import duties which are lower than the cost advantage enjoyed by
the lowest cost foreign good.
THE CASE FOR FREE TRADE
The classical economists were in favour of the free trade policy. Of the modern
economist, Haberler advanced the following arguments in favour of free trade.
1. Maximisation of Output. The case for free trade arises from the theory of
comparative advantage which states that a country specialises in the production of
those commodities in which it possesses greater comparative advantage or least
comparative disadvantage. Therefore, under free trade a country specialises in the
production of those commodities which it is relatively best suited to produce and

exports them in exchange for those imports which it can obtain more cheaply. This
maximises the output of all the participating countries because all gain from trade
which, in turn, increases the real national income of the world economy. Thus free
trade leads to the maximisation of output income and employment.
2. Optimum Utilisation of Resources. Free trade leads to international specialisation
and geographical and territorial division of labour. Each country specialises in the
production of those goods for which it has abundant supply of natural resources. As a
result, the existing resources in each trading country are employed more productively
and the resource allocation becomes more efficient. There is more efficient utilisation of
factors within a firm or industry. Thus international trade and division of labour leads to
optimum utilisation of resources.
3. Optimisation of Consumption. Free trade secures the optimisation of consumption.
In other words, it benefits the consumers when they are able to buy a variety of
commodities from abroad at the minimum possible prices. This, in turn, has the effect of
raising their standard of living.
4. High Factor Incomes. Under free trade, there is perfect mobility of factor of
production. They can move from one place to another and between countries in order to
earn more. Thus such factor incomes as wages, interests, rents and profits are high under
free trade. There is increase in the real income of the world economy and of its
participant countries.
5. Educative Value. According to Haberler, free trade has an educative value.
International competition encourages home producers to sacrifies leisure in order to
increase productivity. For this, they innovate and bring improvements in organisation
and methods of production.
6. Wide Markets. Free trade leads to wide extent of markets for goods. As the demand
for goods is not confined to one country but to a number of countries, the entire world
becomes the market for all types of goods. This leads to the production of quality goods
at low prices because of world competition.
7. Prevents Monopolies. Free trade prevents the establishment of monopolies. Under
free trade each country specialises in the production of a few commodities, and the firms
or industries are of the optimum size so that the cost of production of each commodity is

the minimum. Thus free trade ensures a lower price for exports as well as imports and
the price mechanism under perfect competition prevents the formation of monopolies.
8. Encourages Inventions. Free competition and trade encourage nations to produce the
best and the cheapest products in order to gain more. It stimulates them to invent new
techniques and processes of production, to find new markets, new sources of raw
materials, etc.
9. Develops Transport and Communications. Free trade encourages the development
of the means of transport and communications not only within countries but also among
countries. Rail, road, sea and air transport systems expand with better and more cargo
facilities which move safely and quickly globally. The development of internet, E-Mail
and E-Commerce has been possible due to more freed trade globally.
10. Promotes International Co-operation. Free trade also promotes international co-
operation among nations. To solve bilateral and multilateral trade problems, different
countries come into contact with each other, hold trade talks with among each other.
International organisations like WTO are meant to solve trade problems and promote
international co-operation.
11. Best Policy for Economic Development. Haberler points out that ―substantial free
trade with marginal, insubstantial corrections and deviations is the best policy from the
point of view of economic development.‖
Besides, the direct gains of free trade noted above, free trade fosters development in the
following ways :
(a) it leads to the importation of capital goods, and raw materials;
(b) it instills new ideas, and brings technical knowhow, skills, managerial talents and
entrepreneurship to the developing countries;
(c) it facilitates the flow of foreign capital; and Lastly, it fosters healthy competition and
checks inefficient and exploitative monopolies.
THE CASE AGAINST FREE TRADE
The policy of free trade, with all its advantages noted above, was abandoned after the
Great Depression by the countries of the world. There are certain theoretical and
practical difficulties in following the free trade policy.
1. Laissez Faire and Perfect Competition do not Exist.

Free trade presupposes the existence of laissez-faire and the working of price mechanism
under prefect competition. But these conditions do not exist in the present day world.
Monopoly, monopsony, cartels, imperfect labour markets and tariffs led to the
abandonment of free trade.
2. One-sided Development. Under the policy of free trade, some industries expand in
which the country possesses comparative advantage but other industries are not
developed. An agricultural country may develop only agriculture and neglect the
industrial sector. Or, one type of industries may be developed while others may remain
undeveloped. This naturally leads to the one-sided development of the economy.
3. Production of Inferior and Harmful Goods. There being no restrictions on the
movement of goods under free trade, substandard and harmful commodities are likely to
be produced and traded. This leads to diminution of social welfare. Trade restrictions on
the import of such commodities become necessary.
4. Cut-throat Competition and Dumping. Countries with better factor endowments are
able to produce certain commodities cheaper than others. This led to cut-throat
competition in the world market under free trade. So certain countries like Japan resorted
to the policy of dumping whereby they would sell huge quantities of their products at
rock-bottom prices in the foreign markets. Naturally, this policy led to the imposition of
trade restrictions.
5. Emergence of Multinational Corporations and Monopolies.
Free trade leads to the emergence of international monopolies and local monopolies,
according to Haberler. Such monopolies developed with the spread of multinational
corporation under free trade which proved harmful to the other countries and the
domestic interests. This factor also led to the adoption of the policy of protection.
6. Exploitation and Colonisation of Countries.

Economists do not agree with Haberler that the free trade policy helps in the development
of under-developed countries. Rather, this policy led to the exploitation and colonisation of
countries during the 19th and early 20th centuries.
7. Economic Dependence. Free trade leads to economic dependence which is harmful
for a backward country. Such a country has to depend on the imports of varied types of

consumers and capital goods, raw materials, etc. On developed countries both in war and
peace.
8. Trade Cycles. Free trade leads to international business fluctuations. Booms and
depressions spread among countries. But the danger of depression is more as was the
case of the Great Depression of the 1930s. Depression in America spread to the whole
world, except Russia which was a closed economy at that time.
2. PROTECTION MEANING
The term protection refers to a policy whereby domestic industries are to be protected
from foreign competition. The aim is to impose restrictions on the imports of low-priced
products in order to encourage domestic industries, may be protected by imposing import
duties which raise the price of foreign goods by more than the price of domestic goods.
Or, they may be protected by quotas or other non-tariff restrictions which make imports
of cheap foreign goods difficult or impossible. Or, the domestic industries may be paid
subsides, or bounties to enable them to compete with cheap foreign goods.
ARGUMENTS FOR PROTECTION

Haberler has divided the arguments for protection into two groups: economic and non-
economic. We discuss these one by one. A. Economic Arguments. The economic
arguments which are usually given in favour of protection are :
1. Terms of Trade Argument.
The terms of trade argument is given to correct disequilibrium in the balance of

payments of a country. It is argued that the imposition of a tariff on imports improves

the rate at which the country‘s exports are exchanged for improts. This means that a
tariff improves its terms of trade because the foreign exporter is forced to pay some
part of the import duty. The extent to which a country can improve its terms of trade
by imposing import duty will depend upon the relative demand and supply
elasticities at home and abroad. A country which imports a large quantity of a
particular commodity, whose demand is less elastic, will be in a better position to
impose a tariff duty and improve its terms of trade than a country which imports a
small quantity of a given commodity whose demand is elastic.* The improvement in
the terms of trade by imposing tariff is illustrated in Fig. 1. In the figure, the offer
curves of England and Germany before the imposition of tariff are OE and OG
respectively. The initial terms of trade are given by the line OT. England is exporting
OC of cloth and importing OL of linen from Germany. Suppose a tariff is imposed
on Germany‘s linen by England. It shifts the offer curve of England from OE to OE1
. This changes the terms of trade from OT to OT1 in favour of England. Now
England exports OC1 of cloth in exchange for OL1 of linen from Germany. It now
exports CC1 less of cloth than before and imports LL1 less of linen. Since the
quantity of exports reduced as a result of tariff by England is greater than the
quantity of imports reduced by Germany (CC1 >LL1 ), the terms of trade have
definitely moved in favour of England. However, there are certain adverse effects on
the tariff imposing country, First, the term of trade may improve but the volume to
trade of the tariff-imposing country is reduced. Second, the imposition of tariff
increases the price of the imported commodity to the domestic consumer. Third, it
may lead to retaliation by the other country. Thus too high a tariff leads to reduction
in consumers‘satisfaction, mal-allocation of domestic resources with the reduction in
the volume of trade, and retaliatory tariffs harm the economies of both the countries.
2. Bargaining or Retaliation Arguments. It is argued that the imposition of tariffs is necessary to
bargain in trade negotiations with other countries. Since international trade is based on
reciprocal basis, tariff is used as a weapon to persuade or dissuade the other country to lower
its tariff wall. Thus the fear of retaliation may induce countries to give reciprocal concessions
to each other. But the bargaining argument for protection is not sound on many counts.

First, tariffs as a weapon for bargaining may lead to retaliation on the part of the
other country, thereby harming both the countries.
Second, vested interests may be created in the country which may be so powerful
that they may not allow reduction in tariffs and reciprocal bargaining.
Third, retaliation may lead to economic sanctions between countries and to rivalry.
Fourth, it may lead to the shrinkage of world trade..
3. Anti-dumping Argument. Protection is advocated against the practice of dumping. Dumping
means selling a product in a foreign market at a lower price than in the home market, after taking
into account transport and other costs of transfer. Dumping aims at flooding a foreign market
with low-priced commodities. As a result, the import competing firms are ruined. To protect
such firms, a high tariff is imposed. This will raise the price of the product in the importing
country and removes the threat of dumping.
4. Diversification Argument. Another argument advanced in support of protection is to
diversify the domestic industries. It means that there should be a balanced growth of the
economy so that all the sectors of the economy develop side by side. For this purpose, agriculture
and manufacturing industries should be protected from foreign competition. This is a valid
argument, for experience has shown that countries which are not developed in a balanced way
are affected more by international economic disturbance, such as crop failures, depressions,
inflations, wars, etc. Therefore, they should diversify and become self-sufficient by protecting
their industries. But it is not possible to diversify completely and attain self-sufficiency even by
the richest country of the world. In fact, no country has all resources for a balanced growth of the
economy. It has to depend upon other countries in one way or the other. Moreover, protection is
not the only means to diversify an economy. 5. Infant Industry Argument. The infant industry
argument is the oldest and the most accepted argument for protection. It was formulated by
Alexander Hamilton in 1790 and was popularised by Friedrich List in 1885. This argument ―rests
on the assumption that the country has a latent comparative advantage in the industry or group of
industries to be protected.‖ It is, therefore, argued that if industries in their infancy are not
protected from established foreign producers, they must attain the optimum size so as to operate
most efficiently and competitively and to produce at lower costs. Protection is also needed to

facilitate the flow of resources into infant industries, even though consumers have to bear the
burden of higher prices temporarily. Further, there may be ―imperfection of the information
flow‖ to infant industries in the form of difficulty to borrow funds for investment, knowledge of
infrastructure facilities, labour market,etc. All these requires government protection to such
industries. The economic justification lies in that social benefits exceed private benefits from
investment in such industries. It means that the protection should be given to those infant
industries which generate larger externalities than other industries not given protection.
Moreover, infant industries require time to undergo the process of learning-by-doing to become
competitive in the long-run. Therefore, they should be protected. Johnson regards the infant
industry arguments as being explicitly dynamic arguments ‗for temporary intervention of correct
transient distortion.‘3 So infant industries need protection for a while so that they may grow
without any threat from foreign producers. When they attain adulthood, protection can be
withdrawn and then they should be left free to face foreign competition.
The case for infant industry protection is based on the argument that when a new industry is
started, it cannot reap the economies of scale and its cost of production is high as compared with
its foreign competitors. But if it is protected by providing all types of facilities, such as subsidies,
heavy import duties on foreign goods. etc . It may expand and enjoy internal economies of scale.
It may, in turn, lead to external economies for all firms within the industry in the form of lower
costs of production through the availability of trained labour force, advanced production
techniques, research facilities, etc. If infant industry protection is given to several industries
simultaneously, several external economies accrue in the form of road, railway, power, technical
and research facilities, etc. Moreover, protection to infant industry, leads to its expansion and a
lowering of costs and prices which, in turn, benefits industries using the products of the protected
industry. But protection results in lowering of welfare because a tariff increases production and
consumption costs in the economy. Therefore, to increase social welfare, the infant industry must
be protected and pass what is called Mill‘s test. This test requires that it should be protected
temporarily and must grow up and be able to compete on equal terms at world market prices with
foreign producers in domestic and world markets. For protection to be profitable, it should be
able to pay back the losses incurred due to protection during the infancy period. After that,
protection should be withdrawn. But Bastable suggested another test called Bastable‘s test which
an infant industry must also pass. This test requires that the infant industry must be able to cover

the costs of protection during its infancy by lowering production costs. If an industry passes
these two tests, then only it should be given infant industry protection.
Fig 2
The infant industry argument for protection is illustrated in Fig. 2. Suppose the production
possibility curve of a small country is SS. Under free trade, the TOT (international terms of
trade) line T1T1 which is tangent to the SS curve at point P1 . Where the country produces the
two commodities exportable wheat and importable cloth. After exporting some wheat, it
consumes the two commodities at point E1 on the community indifference curve CI1 . In order
to protect its infant cloth industry, the country imposes a prohibitive tariff on the imports of
cloth. This import tariff changes its TOT in favour of cloth, as represented by the line TT. This
line is tangent to the SS curve and the CI curve at point P so that the country produces and
consumes the two commodities at this point. But despite the imposition of tariff on imported
cloth, the country is at a lower level of welfare because the curve CI is below CI1 curve. There is
loss in community welfare. But this is only a short-run situation. In the long run, protection
increases the production of cloth. This enables the cloth industry to reap the available internal
economies and to increase in its productive capacity. This shifts outward the production
possibility curve SS to SS1 but without any expansion in wheat. When the infant cotton industry
grows and is in a position to face foreign competition, the country removes the tariff and returns
to free trade. Assuming that the same international TOT prevail as before, with the imposition of
tariff, the new TOT is T2T2 (parallel to T1T1 ) which is tangent to the production possibility
curve at P2 where the country produces both wheat and cloth. But it exports cloth and consumes
both commodities at point E2 on the CI2 curve. Now the country is at a higher level of welfare
when compared with the earlier free trade situation beause the curve CI2 is above the CI1 curve.
It may be noted that protection to the cloth industry may continue for many years before it grows
and becomes competitive. Thus the infant industry needs protection for a specified period of time
till it is able to face foreign competition. It is then that the tariff should be withdrawn and at the
same time the increase in community welfare should be more than compensate for the loss in the
earlier years so that there are net benefits to the community.
Its Criticisms.
The infant industry argument for protection has been severely criticised by economists on the
following grounds :
1. Difficult Decision. It is difficult to decide which industry needs protection because every
industry is in its infancy to begin with. In fact, it is difficult to select genuine infant industries
because it requires ―forecasting the potential cost structure of an industry, and its established
competition.‖
2. Lack of Reliable Criteria. Protection is given to an infant industry with the promise that it
would be withdrawn after a few years when the industry attains adulthood and is able to face
foreign competition. But it is difficult to decide about this due to the lack of any reliable criteria.
3. Vested Interests. Once protection is granted to an industry, vested interests are created which
do not want the removal of duties. Thus as pointed out by Haberler, ―temporary infant-industry
duties are transformed into permanent duties to preserve the industries they protect.‖
4. Difficult to Remove Duties. Even if a part of the industry is able to stand upon its feet, a
number of less efficient concerns are established behind the shelter of tariffs which make it
difficult to remove the duties.
5. Monopoly Profits. Some of the industrialists who start making monopoly profits under
protection do not want the removal of duties. They, therefore, bribe the legislators and corrupt
the general politics of the country.
6. External Economies do not Exist. Haberler does not agree with the view that the
development of infant industries leads to internal and external economies of production. He has
shown that alleged possibilities of external economies under infant industry protection are vague,
muddled and doubtful ―so that arguments for tariffs based upon them belong to curiosa of theory
rather than to a practical economy theory.‖

LDCS AND INFANT INDUSTRY ARGUMENT
The infant industry argument for protection is generally applicable to LDCs. LDCs can have
potential comparative advantage in one particular
Fig. 3
The infant industry argument for protection is generally applicable to LDCs. LDCs can have
potential comparative advantage in one particular commodity. But due to small initial level of
production and lack of knowledge, the initial production costs of the industry are very high. As a
result, such an industry cannot be developed in the face of foreign competition. Therefore, it
becomes necessary for an LDC to impose tariff in order to establish and give protection to an
industry in its infancy. Such protection is justified so long as the indusrty does not develop in
size and efficiency to such a level as to compete with foreign competitors. This is explained in
Fig. where OPw is the world price of that commodity in which the LDC has a potential
comparative advantage. But in the beginning, the production cost of this commodity is OPL in
LDC which is higher than the world price OPw. That is why this industry cannot be established
or developed without protection in LDC against foreign competition. Therefore, to protect this
industry, import tariff higher than Pw–PL on this commodity can be imposed. When the infant
industry expands in the long run, production increases and the industry reaps the economies of
large scale production which reduces the production cost of the industry as shown in the figure
from OQ1 quantity onwards. When the industry expands further, its output OQ2 equals the world

price at point E. The protection on the industry can be removed now. After point E, the
production cost being lower than the world price, the LDC can export this commodity.
The infant industry argument explained above is meant to encourage domestic production of the
commodity. It is based on the argument that Nurse the baby, protect the child and free the adult.
It means that unless an industry becomes capable of competing with foreign producers,
protection should not be removed. But when it is able to face foreign competition, protection
should be withdrawn. But the experience is that once protection is given to an industry, it likes to
remain an infant industry for ever. Again, when an industry is protected through import tariff, it
becomes difficult to remove it.* Therefore, economists prefer production subsidy to an import
tariff. First, A subsidy is superior to a tariff because it leads to more consumption at point E1 on
the CI1 curve than at point P on CI curve in Fig. 2. Second, if there is a properly functioning
capital market, the profitability of the protected industry may lead to long term investment in it.
Third, a subsidy can be reviewed every year, being a part of the annual government budget.
Fourth, a subsidy can be raised or reduced according to the requirements of the protected
industry without distorting relative prices and domestic consumption. But these arguments
against an import tariff do not hold ground in LDCs because they lack a developed capital
market, and even necessary knowhow to operate an infant industry. Moreover, a subsidy is a big
burden on the tax revenue system, while a tariff brings much needed revenue to the government.
In the light of the above arguments, it can be concluded that the infant industry argument is
suited for LDCs.
6. Sunset Industries Argument. This is a very recent argument for protection which has
emerged in Europe. From the 1970s onwards, some established labour-intensive industries
such as producing steel products, textiles, clothing, footwear, etc. have been losing
competitiveness to Japan, Taiwan, Malaysia, Korea, India and other East Asian countries. This
argument implies that sun is setting on such mature industries of Europe which should be granted
temporary protection so that they may be able ―to re-equip and regain competitiveness‖. In the
absence of protection, it will lead to displacement of labour and capital in such industries. This
has actually led to the imposition of import tariffs on textiles, clothing, footwear and such
products in the European Countries. However, critics point out that is a political argument to

solve the unemployment problem in such countries. Moreover, once protection is granted to such
industries, it is difficult to remove tariffs.
7. Socially Important or Key Industries Argument. Protection should be given to socially
important industries such as agriculture or strategically important industries as iron and steel,
heavy electricals, machine making, heavy chemicals, etc. There is no dispute over this argument
because the development of key and other socially important industries under protective tariffs is
one of the principal aims of trade policy in a country.
8. Employment Argument. A usual argument for protection is that it is a cure for
unemployment. The imposition of a tariff reduces imports and encourages employment directly
in import competing industries. This, in turn, generates employment in other industries
dependent upon this import-competing industry and may even spread to import-substitution
industries. According to Prof. Haberler, unemployment in one single industry can be reduced by
a tariff on the competing imports provided the demand for its products is not completely elastic
and its products compete with similar imported products. But this does not mean that total
unemployment will diminish. The critics argue that a tariff is not likely to reduce unemployment
because a restriction of imports will lead to reduction of exports. While unemployment may be
reduced in import-competing industries, it will increase in exports industries. As pointed by
Keynes, ―If a reduction of imports causes almost at once a more or less equal reduction of
exports—obviously a tariff . . . would be completely futile for the purposes of argumenting
employment.‖
Keynes gave to arguments to show that a protective tariff might lead to increase in employment,
provided exports are maintained at the old level,
First, if the tariff-imposing country lends to foreign countries, its exports can be maintained at
the old level, and the increase in the employment in the import-competing industries will not be
offset by reduction in employment in export industries.
Second, exports can be maintained at the old level, if subsidies are given to export industries out
of the revenue from import duties. But critics do not agree with Keynes on the adoption of these
methods. They argue that lending to other countries would divert capital resources from home
investment which would reduce domestic investment, thereby reducing total employment in the
country, On the other hand, the grant of subsides to export industries would lead to retaliation by
other countries which would levy anti-dumping duties. Thus, it is not possible to increase

employment by imposing a protective tariff. Prof. Haberler has analysed the effect of tariffs on
the various types of unemployment.
First, unemployment may be frictional which arises from changes in the industrial structure as a
result of the adoption of new investments and methods of production. Such technological
unemployment can be removed by imposing a new tariff duty on imports only in the case of one
industry, but not in the case of the entire industrial structure of the economy. Therefore,
technological unemployment can be removed by protection, for it ―involves the abandoning of
all the fruits of technical progress, in so far as they can be enjoyed only through the medium of
international division of labour.‖
Second, unemployment may be due to the cyclical fluctuations of the industry. Cyclical
unemployment can be reduced by a new tariff duty on one industry but not in the case of
numerous industries and countries. Heavy protection in America in the 1930s failed to prevent
crises and depression. As pointed out by Heberler, ―Whether a country has high or
low tariff has nothing to do with the acuteness of its crises and depression.‖
Third, there may be permanent unemployment which can again be removed by the imposition of
a new tariff duty in the case of one industry but not for the entire economy. However, only high
tariffs can cure permanent unemployment if it is due to very high wages. But high tariffs lead to
retaliation. Under the circumstances, it is not high tariffs but readjustment of wages are needed to
cure permanent unemployment. Haberler concludes that ―leaving aside a few exceptional cases, a
favourable result can be expected only in the short-run, so that tariffs can be advocated on this
ground only from a short-run, and indeed, indeed, short-sighted, standpoint.
. 9. Balance of Payments Arguments. This is one of the important arguments for protection,
especially by LDCs. Tariffs help in restricting the imports of unnecessary goods and try to
reduce the balance of payments deficit. They assist in conserving foreign exchange which can be
used for importing essential goods and services for import-substitution industries and for the
export sector. The expansion of the import-substitution and export sectors, in turn, raises
employment and income in the country. And the increase in income increases savings and the
supply of loanable funds which reduce the interest rate and encourage investment. Consequently,
more employment and income are generated.
Fig. 4

In fact, both developed and less developed countries have used tariffs as an effective instrument
to reduce their balance of payments deficits. This is illustrated in Fig. 4 where D is the domestic
demand curve and S the domestic supply curve of importables. OP is the constant world price at
which the importers are prepared to sell their commodities in the domestic market. Thus the
horizontal line PB is the supply curve of imports which is perfectly elastic at OP price. Under
free trade (before the imposition of a tariff) the equilibrium market position is given by point B
where the domestic demand curve D intersects the world supply curve PB at price OP. The total
demand for importables is OQ3. The domestic supply is OQ. The difference between domestic
demand and domestic supply is QQ3. The imposition of a tariff by PPT amount raises the
domestic price to OPT and reduces the deficit from QQ3 to Q1Q2 because domestic demand is
OQw2 and domestic supply is OQ1 and OQw2 – OQ1 = Q1Q2. But when the export surplus
increases employment and income in one country, the import surplus in the other country
reduces employment and income there. Second, such a policy will lead to retaliation by the other
country. Third, this policy adversely affects the volume of world trade, and international
specialisation suffers. Therefore, Johnson does not regard the imposition of tariffs to reduce
balance of payments deficit as an optimum policy and prefers a cut in domestic expenditure or
devaluation to tariffs.
10. Factor Income Redistribution Argument. Another argument, particularly related to
LDCs, is to redistribute income. There is a large labour-intensive sector with low
incomes and a small capital-intensive sector with high incomes. The latter sector is

mainly dependent on imports. It is argued that the imposition of tariffs on the imports of
this sector will encourage the production of the labour-intensive sector where real
incomes will rise. Factors of production will move from the former to the latter sector in
the long run. However, the capital-intensive sector releases more capital but less labour
which the expanding labour-intensive sector wishes to absorb. This causes wages in the
labour-intensive sector to rise even more. At the same time, wages in the capital-intensive
sector rise because the producers find it difficult to retain workers from moving to the
other sector. Eventually, both the industries pay equal wages. Thus tariffs lead to
equalisation of factor incomes in the long-run growth process. But, in reality, factor
incomes are never equalised. Rather a tariff may harm the scarce factor more than it may
benefit the abundant factor in such countries due to inherent sociological, political and
economic constraints. But tariffs are not the most efficient instrument for redistribution of
income. The best course is to resort to lumpsum redistributions of income without
causing malallocation resources by taxing the high-income groups and giving the
proceeds to low-income groups through various incentives and providing productive
employment opportunities.
11. Revenue Argument. Tariffs are levied to generate revenue for the government and to
protect domestic industries from foreign competition. In LDCs, revenue collection is
considered the main objective of import and export tariffs. This is not a correct view
because raising revenue is a by-product of protection to domestic industries. However, if
such governments depend more on tariffs as a source of revenue, it may lead to some
negative side-effects. If the demand for imported goods is fairly inelastic, tariffs may
bring more revenue. On the contrary, in the case of highly elastic demand, tariffs may
stop trade altogether and reduce the government revenue. Similarly, taxes (duties) on
exports reduce the sales of exports and foreign earnings, thereby creating balance of
payments difficulties.* Despite these demerits, LDCs prefer tariffs for raising revenue
because they are easy to levy and less expensive to collect than other direct and indirect
taxes. But the tariff rates should not be so high as to become prohibitive and harmful for
the country. So far as the burden of import tariffs on domestic importers and foreign
exporters is concerned, it depends on the price elasticities of demand and supply for the
goods. If the demand for imports is relatively elastic and the supply exports is relatively

inelastic, the main burden of the tariffs will fall on the foreign exporters. In case the
demand for imports is relatively inelastic and the supply of exports is relatively elastic,
the major burden will be borne by the domestic importers. Two questions arise :
Fig 5
What is the specific rate of tariff which maximises the tariff revenue? Is the optimum
tariff which maximises the tariff revenue? The answers to these questions are : the first is
the maximum tariff revenue rate. The second is that the optimum tariff does not
maximise the tariff revenue. It is not the maximum tariff revenue rate. Consider, Fig. 5
where the upper curve represents the optimum tariff. As the tariff rate increases along this
curve, welfare also increases. At the OT tariff rate, welfare
is the maximum at M but the tariff revenue is not. When the tariff rate is increased
further, the total revenue continues to rise till OT1 rate. This is the maximum tariff
revenue rate. The total revenue is the maximum at point R on the ORT2 curve. If the
tariff rate is increased beyond this maximum rate, revenue will begin to fall from R till it
reaches the prohibitive tariff rate OT2. In this situation the tariff rate is so high that
imports stop and the revenue is zero. Thus the optimum tariff is not the maximum tariff
revenue rate. In fact, the maximum tariff revenue rate is higher than the optimum tariff
rate. This rate maximises the country‘s welfare upto the T2W level. 12. Domestic
Distortions Argument. The domestic distortions argument for tariff is based on the fact
that the domestic factor and commodity markets in an economy do not work under fully
competitive conditions. Rather, there are market failures or imperfections in these
markets which lead to domestic distortions. Market failures or distortions are due to

monopolies, the problem of externalities (external economies or diseconomies), wage
differentials, trade unions, government activities or regulations. The basic idea is that
when distortions exist in an economy which prevent it from operating under perfectly
competitive conditions, the government should use a tariff to cancel partially the effects
of such distortions. This is the second best policy.
The use of tariffs to remove domestic distortions requires answers to three
questions. First, is tariff better than free trade to increase welfare? Second, is tariff better
than other forms of trade interventions by the government in increasing welfare? Third,
which is the optimal policy for the government to adopt? To answer these questions, an
optimum situation requires : DRS = DRT = FRT where, DRS is the domestic rate of
substitution in consumption, i.e. the slope of the social indifference curve, CIC. DRT is
the domestic rate of transformation in production, i.e. the slope of the production
possibility curve for home production between any two commodities. FRT is the foreign
rate of transformation i.e. the slope of the world price line or international TOT.
DOMESTIC DISTORTIONS IN COMMODITY MARKETS Domestic distortions in
commodity markets are due to the existence of external diseconomies of production or
negative production externalities. These lead to divergencies between social and thus
require protection to domestic industry. Private costs of production and suppose a country
produces an exportable commodity wheat and an importable commodity cloth. Further,
there are diseconomies in the production of wheat which

are not reflected in its private cost of production. This means that the private cost of
producing wheat is lower than its social cost. Thus the domestic relative prices do not
reflect the social marginal rate of transformation in production. In such a situation, free
trade may reduce welfare as compared to antarky. This is illustrated in Fig. 6 where AA1
is the production possibility curve of say country A which reflects its social marginal rate
of transformation between wheat and cloth. Because of distortions in the production of
wheat, the domestic terms of trade line is TDTD and the country produces and consumes
at point P under antarky.
Suppose the international TOT line is T0 T0 which shows a comparative advantage in
exporting wheat, the price of wheat being higher in the world market due to domestic
distortions in comparision to the importable cloth. Now under free trade the country will
increase its production of wheat to point P0 , export some of it and consume the rest at
point C0 on the CI0 curve which is lower than the CI curve under autarky. In this case,
the community welfare has declined because domestic distortions have led the country to
specialise in the wrong commodity wheat in which it does not possess comparative
advantage. But the true comparative advantage will be if the international TOT is the
dotted T1T1 line where the country will consume at C1 on the CI1 curve which is higher
than the CI curve under autarky. Therefore, the country will be better off with free trade.
According to Bhagwati and Ramaswami, this need not always happen and the consumers
may be worse off. Hence the first-best policy is to solve the distortion problem by a
domestic tax-cum-subsidy under free trade, instead of levying a protective tariff. In this
case, a tax on the production of wheat or a subsidy on the production of cloth or both
would lead the country to maximise welfare when production takes place at P2 , where
the international TOT is T2T2 line (parallel to T0T0 ) is tangent to the production
possibility curve AA1 and consumption takes place at C2 on the highest curve CI2.
DOMESTIC DISTORTIONS IN FACTOR MARKETS

Fig 7
Domestic distortions in factor markets exist due to wage differentials and immobility of
labour among industries and rigidity of wages on the labour market side, or rationing of
credit in capital markets. Such distortions necessitate protection to domestic industry
because there is inefficiency in resource allocation. For instance, labour is
underemployed and unemployed in the agricultural sector in LDCs whose wages are low
as compared to high wages in industry. This leads to divergence in the social and private
cost of labour i.e. the private cost of labour in industry is much higher than the social cost
of labour in agriculture. This shows inefficiency in resource allocation because labour is
not being paid the same wage rate in both sectors of the economy. For an optimum
resource allocation, protection to domestic production should be given either in the form
of tariff or subsidy or both. The effect of distortion on the factor market is shown on a
diagram by drawing a production possibility curve, such as the broken curve APA1 ,
inward towards the O-axis in Fig. 7. Suppose under free trade at the international TOT
line TT , the country is producing at P and consuming at C . To remove distortion, the
country imposes a prohibitive tariff which leads to production at P1 and consumption at
C1 . As a result, the welfare has increased because the new CI1 curve is at a higher level
than the CI curve. But such a tariff is not an optimal policy because the international TOT
line T1 T1 is not tangent to the domestic production possibility curve APA1 at point P1.
So the better policy would be to give a production subsidy to the industrial commodity

cloth. The right subsidy takes the coun try to the distorted curve APA1 at point P2 where
the slopes of the production possibility curve APA1 and the international TOT line T2T2
are equal. The social welfare also increases under subsidy than under tariff because the
CI2 curve is at a higher level than the CI1 curve. Again, a subsidy on production is not
the best policy because it has not been able to remove the distortion in the factor market.
The first best policy is to use a tax-cum-subsidy on the distorted factor labour so as to
equalise the wage rate. A tax on employing labour in agricultural sector producing wheat
and a subsidy to industrial sector producing cloth for employing labour would take the
country to the undistorted solid production possibility Curve AP3A1. Thus the optimal
production point on this curve is P3 as against P2 and C2 respectively under subsidy.
Conclusion. To conclude, if distortions exist in the commodity markets and factor
markets, a tariff is not an optimal solution. The first best solution is a tax-cum-subsidy on
the commodity in the case of a commodity market and on the distorted factor in a factor
market. 13. Strategic Trade Policy Argument. The strategic trade policy argument is
based on the development of high-technology industries in developed countries which
need protection against foreign competition. It is argued that modern industries in the
fields of information technology, tele-communications, computers, etc. are capital-
intensive R & D (Research & Development) oriented, high-risk oriented, lead to large
external economies and have high growth prospects for the country. They therefore, are
required to be protected in order to have a comparative advantage over other competing
countries. Thus this argument is similar to the infant-industry argument for LDCs. But
this policy has certain limitations. First, it is difficult to lay down criteria and pick up
industries which have large external economies. Second, it is also a problem to lay down
appropriate policies so as to develop high-tech industries. Third, almost all developed
nations adopted strategic trade policies simultaneously. Consequently, their efforts to
protect their industries are neutralised. So they may not be able to benefit much from
protection. Fourth, even if a country is successful by following this policy, it is at the cost
of other countries who are likely to follow a retaliatory policy.
14. Conservation of National Resources Argument. Countries which export minerals
and raw materials always fear that there exports would ultimately exhaust them.
Therefore, protection to such exhaustible national resources as coal, manganese, mica,

iron, etc. is essential to conserve them for the future development of the country. This is
done by restricting their exports through high export duties.
15. Pauper Labour Argument. It is argued that goods produced by workers getting high
wages in one country cannot compete with goods produced by low-wage workers in the
other country. Therefore, high-wage domestic goods should be protected from low-wage
imported goods by imposing tariffs. This argument is based on two unrealistic
assumption. First, the prices of goods are determined by wage rates alonge, and Second,
labour is the only factor of production. But the fact is that goods are manufactured by a
combination of factors. Labour is combined with land and capital. It is only in the labour-
intensive goods that low-paid labour can have a cost advantage over high-paid labour. It
is, therefore, fallacious to argue that a high-wage country is at a disadvantage in the
production of all types of commodities. Further, it is wrong to assume that the cost of
production is high in the high-wage country. In fact, high wages may be due to high
productivity. So in a country where labour productivity is high. per unit cost of
production may be lower than the low-wage country. Consequently, when unit costs are
low in the high-wage countries they can compete with low-wage countries.* Stopler and
Samuelson have shown under some rigid assumptions that protection can support the
level of wages in a country. In a country where labour is scarce, free trade will enable
labourintensive imports to enter. As a result, labour scarcity will be reduced, thereby
reducing the wages of labour relative to the return on capital. So protection is justified
because it will raise the wages of the scarce factor labour and reduce the return on the
abundant factor capital. The Stopler-Samuelson theorem does not support the pauper
labour argument. It simply reveals that protection can lead to a redistribution of real
income in favour of labour. But the real wage of labour can be increased in a better way
by monetary and fiscal measures and benefits from free trade can also be enjoyed. Thus
protection provides no solution to the fallacious pauper labour argument.
16. Keeping Money at Home Argument. This is also one of the fallacious arguments
for protection. This argument runs as follows: ―When we buy manufactured goods abroad
we get the goods and the foreigner gets the money. When we buy the manufactured
goods at home we get both the goods and the money.‖ This saying by Robert Ingersoll is
wrongly attributed to Abraham Lincoln. This argument is illogical because if every

country were to follow this rule, there would be no international trade and the benefits of
its would not accrue to any country of the world. A country buys goods from another
country because the latter offers them at lower prices than the domestic manufacturers.
Buying goods produced by domestic manufacturers would, therefore, mean loss to the
consumers. Moreover, in international trade domestic currency cannot be used for
making payments to foreigners. In fact, goods pay for goods, and payments if any are
made in the international currency. Thus, as pointed out by Beveridge, this argument ―has
no merits; the only sensible words in it are the first eight words‖ in the above cited
quotation.
17. Expanding Home Market Argument. This is a corollary to the above argument of
keeping money at home. Accroding to this argument, protection should be given to new
industries and the workers engaged in them would create a good market for other
domestic products. This would expand the home market for all domestic products
including agricultural commodities. This is again a fallacious argument because the home
market would expand at the expense of the foreign market for exports. When imports are
restricted by imposition of tariff duties, exports also decline because other countries
would retaliate. Moreover, domestic producers will charge higher prices for the products
of domestic industries and the consumers will be the losers.
18. Scientific Tariff, or Equalising Costs of Production Argument. Protection to
domestic industries is advocated for equalising costs of production or prices of domestic
and foreign products. If, for example, the domestic costs are higher than foreign price by
25 per cent , an import duty of 25 per cent should be imposed on the foreign products.
Thus the price of both domestic and foreign products are equalised and they can compete
on equal terms. According to Taussig, this argument ‗has an engaging appearance of
fairness. It seems to say, no favours, no undue rates.‖ But strictly speaking, its ―apparent
fairness is only skin deep,‖ according to Ellsworth. If the domestic costs of production
are high, the import duty will also be high. So it is the foreigner who suffers from such a
policy. The imposition of very high import duties by all countries would lead to the
destruction of international trade. Ellsworth also regards such a protection policy as
discriminatory. The imposition of retaliatory tariff duties on the country‘s exports by
other countries harms the efficient domestic export industries. Moreover, such a policy

would lead to giving protection to the least efficient industries with the highest costs of
production. It thus ―discriminates in favour of inefficient producers; against efficient
ones, and against the general body of consumers.‖
B. Non-Economic Arguments. There are three important non-economic arguments for
protection.
1. Defence Argument. A country should adopt the policy of protecting its industries
from the standpoint of national defence. If a country is dependent on other countries for
its requirements of agricultural and industrial products, it will be very harmful for its
national interest in times of war. The argument runs that it is no use amassing wealth and
becoming richer, if the country is not in a position to defend its freedom. As aptly put by
Adam Smith, ―Defence is better than opulence.‖ Therefore, a country should be self-
sufficient as far as possible even if it involves an economic loss in the production of
certain commodities, which are needed for national defence. In particular, protection for
national defence refers to self-sufficiency in arms and ammunitions and other related
industries. But complete self-sufficiency as an argument for national defence does not
carry much force for it will lead to inefficiency in domestic industries and loss of the
gains from international trade. Thus industries which are directly ad indirectly needed for
the manufacture of arms and ammunitions and other war materials should be developed
under protection.
2. Preservation Argument. Protection is advocated to preserve the special ethos of the
nation and certain classes of the population or certain occupations. It is argued that these
would tend to disappear under free trade and their preservation is desired on political and
social grounds. This argument is put forth to safeguard the interests of the agriculturists.
The imposition of agricultural duties on import of farm products is beneficial for the
farmers who would be assured fair prices for their products. They would thus become
prosperous. The prosperity of the peasantry is essential for it forms the backbone of every
nation. As pointed out by Haberler ―Agriculture is the wellspring from which the human
race is physically and mentally regenerated. Therefore, agriculture should be protected
from foreign competition at all costs to preserve the special ethos of the nation.‖
3. Patriotism or Nationalism Argument. To arouse patriotism or nationalism among the
people, imports of foreign goods are restricted through high import duties so that they

consume the goods manufactured within the country. This is what Gandhiji advocated in
his swadeshi movements. For the success of such a policy, it is essential that goods
produced within the country should be of high quality and available in sufficient
quantities.
NEED FOR PROTECTION IN LDCS Various arguments have been put forth in
support of the policy of protection in LDCs. They are discussed as under :
1. Capital Formation. In LDCs, the income of the people being low, they save and
invest less. So the rate of capital formation is low. Domestic savings can be increased by
restricting the importation of luxury consumer goods through prohibitive import duties.
Traded goods become more expensive. The consumption expenditure is thereby reduced
which is equivalent to an increase in savings. This increase in savings is, in turn, utilised
for importing capital goods. Thus the necessary condition for capital formation is that a
reduction in the import of capital goods must be followed by an increase in the export of
capital goods of the same value.
2. Foreign Investment. Protection also acts as a source of capital formation by attracting
direct foreign investment in LDCs. According to Prof. Mundell, protection leads to
additional flow of foreign capital. One of the methods is the setting up of tariff factories
in the tariff imposing country by the foreign manufacturer in order to escape import
controls. The foreign manufacturer may set up a branch or subsidary of his firm alone or
in collaboration with local enterprise behind the tariff wall when the finished products are
prohibited while raw materials and necessary parts are permitted duty free.
3. Revenue. Import and export duties are an important source of revenue for LDCs,
because other revenue sources are limited due to the low level of income and corporate
profits, the existence of large non-marketed output, the lack of an efficient bureaucratic
system, etc.
4. Infant Industries. The famous Listian ‗infant industry‘ argument in favour of
protection gives enough inducement to LDCs in accelerating their pace of
industrialisation. There are some industries which can be fruitfully developed in countries
provided they are protected from foreign competition. The argument is that ‗infant‘
industries need protection from foreign competition till they attain adulthood. The period
between infancy and adulthood is generally by characterized by a transition from the

agricultural to the industrial stage. Myrdal has assigned ―four special reasons for
industrial protection in underdeveloped countries–the difficulties of finding demand to
match new supply, the existence of surplus labour, the large rewards of individual
investments in creating external economies, and the lop-sided internal price structure
disfavouring industry.‖ These reasons are interrelated and provide an ―infant economy‖
case for protection to industries in LDCs.
5. Terms of Trade. LDCs have unfavourable terms of trade in relation to the developed
countries. The imposition of tariffs is essential to shift the terms of trade in favour of
LDCs which increases its gains from trade. If an LDC imposes tariffs that bring about a
fall in import prices or rise in export prices, its terms of trade are improved. lts income
will increase and it will be in a position to import larger quantities of capital goods.
6. External Economies. Another argument for protection in LDCs is the establishment
and development of new industries. Every new industry yields benefits in the form of
external economies. These external economies result in a divergence between private
profit and social benefit. And when such divergence arises, a case can be made for import
restrictions or subsidization in order to lessen this divergence. Prof. Scitovsky maintains
that the concept of external economies in the context of industrialization of
underdeveloped countries is used in connection with the social problem of allocating
savings among alternative investment opportunities. He explains further that with an
expansion in the capacity of an industry as a result of investment, prices of its products
fall and the prices of the factors used by it rise. The lowering of product prices benefits
their consumers and the rising of factor prices benefits their suppliers. When these
benefits accrue to firms in the form of profits, they are further invested and lead to
industrialisation.
7. Factor Redistribution. In an LDC, there is wide difference between wages of
agricultural workers and industrial workers. Due to underemployment in rural areas,
wages tend to be low in agriculture as the marginal product of labour is negligible or
zero. But wages are high in industry. As a result, there is a gap in prices and costs
between agriculture and industry. A policy of protection to industries will compensate for
this gap by providing employment to the surplus labour force in industry. Since

agriculture is less productive than industry, real income can be raised by factor
redistribution through a policy of protection in LDCs.
8. Balance of Payments. One of the principal objectives of protection in an LDCs is to
prevent disequilibrium in the balance of payments. Such countries are prone to serious
balance of payments difficulties to fulfil the planned targets of development. An
imbalance is created between imports and exports which continues to widen as
development gains momentum. This is due to increase in imports and decline in exports.
The imposition of tariffs lead to the restriction of imports and encouragement of exports,
thereby making the balance of payments favourable for the country.
9. Planned Economic Development. LDCs follow the policy of planned economic
development. They aim at the utilisation of their scarce resources in the most efficient
manner so as to provide more employment and income to the people and to raise their
standard of living. This requires the importation of essential raw materials and capital
goods in place of unnecessary consumer goods. This is only possible by levying low
import duties on the former goods and heavy import duties on the latter goods.
10. Diversification and Self-sufficiency. The majority of LDCs have won their freedom
from the colonial rule after much struggle. They want to maintain it by becoming strong
on the economic and defence fronts. These require a policy of protection in order to
diversify their economies so that they become self-sufficient through all-round
development and have self-sustaining growth.

INTRODUCTION
Before we go into the subject matter of this unit, we shall take a quick look into a few
recent developments in the international trade arena.
• On January 27 , 2017 The European Commission, after a detailed investigation

which confirmed dumping ,decided to impose anti-dumping measures on two steel
products (stainless steel tube and pipe butt-welding fittings) originating in China and
Taiwan.
• In April, 2017 India accuses that by deciding to test up to 50 per cent of India‘s
shrimp consignments for antibiotic residues, European Union is using SPS (Sanitary and
Phytosanitary) restrictions in the case of seafood, and also on fruits and vegetables) in an
exaggerated way and that its specifications sometimes exceed the norms prescribed in the
Codex Alimentarius standards of the FAO.
• In April, 2017, India decided to have a domestic purchase preference policy

applicable for five years for PSU oil companies. Targets of local contents (LC) also are
stipulated for certain oil and gas business activities.

• In view of the avian influenza threat, India has in recent years curbed the import
of frozen chicken legs from the US. The WTO upheld the objections raised by the US to
India‘s move, that the curbs are beyond international norms and therefore amounted to
non-tariff barrier.
The above vignettes are just a few of the multitudes of episodes that arise almost on a
daily basis when countries engage in trade. A glance at similar newspaper reports makes
it obvious that governments do not conform to free trade despite the potential efficiency
and welfare outcomes it will promote; rather, they employ different devices for restricting
the free flow of goods and services across their borders.
We have seen that there are clear efficiency benefits from trade in terms of economic
growth, job-creation and welfare. The persuasive academic arguments for open trade
presuppose that fair competition, without distortions, is maintained between domestic and
foreign producers. However, it is a fact that fair competition does not always exist and
unobstructed international trade also brings in severe dislocation to many domestic firms
and industries on account of difficult adjustment problems. Therefore, individuals and
organisations continue to pressurize policy makers and regulatory authorities to restrict
imports or to artificially boost up the size of exports.
Historically, as part of their protectionist measures, governments of different countries

have applied many different types of policy instruments, not necessarily based on their
economic merit, for restricting free flow of goods and services across national
boundaries. While some such measures of government intervention are simple,
widespread, and relatively transparent, others are complex, less apparent and frequently
involve many types of distortions. In this unit, we shall describe some of the most
frequently used forms of interference with trade. Understanding the uses and implications

of the common trade policy instruments will enable formulation of appropriate policy
responses and more balanced dialogues on trade policy issues and international trade
agreements.
Trade policy encompasses all instruments that governments may use to promote or
restrict imports and exports. Trade policy also includes the approach taken by countries in
trade negotiations. While participating in the multilateral trading system and/or while
negotiating bilateral trade agreements, countries assume obligations that shape their
national trade policies. The instruments of trade policy that countries typically use to
restrict imports and/ or to encourage exports can be broadly classified into price- related
measures such as tariffs and non-price measures or non-tariff measures (NTMs).
In the following sections, we shall briefly touch upon the different trade policy measures
adopted by countries to protect their domestic industries.
TARIFFS
Tariffs, also known as customs duties, are basically taxes or duties imposed on goods and
services which are imported or exported. It is defined as a financial charge in the form of
a tax, imposed at the border on goods going from one customs territory to another. They
are the most visible and universally used trade measures that determine market access for
goods. Import duties being pervasive than export duties, tariffs are often identified with
import duties and in this unit, the term ‗tariff‘ would refer to import duties.
Tariffs are aimed at altering the relative prices of goods and services imported, so as to
contract the domestic demand and thus regulate the volume of their imports. Tariffs leave
the world market price of the goods unaffected; while raising their prices in the domestic
market. The main goals of tariffs are to raise revenue for the government, and more
importantly to protect the domestic import-competing industries.
Forms of Import Tariffs

(i) Specific Tariff: A specific tariff is an import duty that assigns a fixed monetary
tax per physical unit of the good imported. It is calculated on the basis of a unit of
measure, such as weight, volume, etc., of the imported good. Thus, a specific tariff of
`1000/ may be charged on each imported bicycle. The disadvantage of specific tariff as
an instrument for protection of domestic producers is that its protective value varies
inversely with the price of the import. For example: if the price of the imported cycle is `
5,000/,then the rate of tariff is 20%; if due to inflation, the price of bicycle rises to `
10,000 , the specific tariff is only 10% of the value of the import. Since the calculation of
these duties does not involve the value of merchandise, customs valuation is not
applicable in this case.
(ii) Ad valorem tariff: An ad valorem tariff is levied as a constant percentage of the

monetary value of one unit of the imported good. A 20% ad valorem tariff on any bicycle
generates a `1000/ payment on each imported bicycle priced at `5,000/ in the world
market; and if the price rises to ` 10,000, it generates a payment of `2,000/. While ad
valorem tariff preserves the protective value of tariff on home producer, it gives
incentives to deliberately undervalue the good‘s price on invoices and bills of lading to
reduce the tax burden. Nevertheless, ad valorem tariffs are widely used the world over.
There are many other variations of the above tariffs, such as:
(a) Mixed Tariffs : Mixed tariffs are expressed either on the basis of the value of the
imported goods (an ad valorem rate) or on the basis of a unit of measure of the imported
goods (a specific duty) depending on which generates the most income( or least income
at times) for the nation. For example, duty on cotton: 5 per cent ad valorem 0r ` 3000/per
tonne, whichever is higher.
(b) Compound Tariff or a Compound Duty is a combination of an ad valorem and

a specific tariff. That is, the tariff is calculated on the basis of both the value of the
imported goods (an ad valorem duty) and a unit of measure of the imported goods (a

specific duty). It is generally calculated by adding up a specific duty to an ad valorem
duty. For example: duty on cheese at 5 per cent ad valorem plus 100 per kilogram.
(c) Technical/Other Tariff: These are calculated on the basis of the specific
contents of the imported goods i.e the duties are payable by its components or related
items. For example: `3000/ on each solar panel plus ` 50/ per kg on the battery.
(d) Tariff Rate Quotas : Tariff rate quotas (TRQs) combine two policy instruments:
quotas and tariffs. Imports entering under the specified quota portion are usually subject
to a lower (sometimes zero), tariff rate. Imports above the quantitative threshold of the
quota face a much higher tariff.
(e) Most-Favored Nation Tariffs: MFN tariffs are what countries promise to impose
on imports from other members of the WTO, unless the country is part of a preferential
trade agreement (such as a free trade area or customs union). This means that, in practice,
MFN rates are the highest (most restrictive) that WTO members charge one another.
Some countries impose higher tariffs on countries that are not part of the WTO.
(f) Variable Tariff: A duty typically fixed to bring the price of an imported
commodity up to the domestic support price for the commodity.
(g) Preferential Tariff: Nearly all countries are part of at least one preferential trade
agreement, under which they promise to give another country's products lower tariffs
than their MFN rate. These agreements are reciprocal. A lower tariff is charged from
goods imported from a country which is given preferential treatment. Examples are
preferential duties in the EU region under which a good coming into one EU country to
another is charged zero tariffs. Another example is North American Free Trade
Agreement (NAFTA) among Canada, Mexico and the USA where the preferential tariff
rate is zero on essentially all products. Countries, especially the affluent ones also grant
‗unilateral preferential treatment‘ to select list of products from specified developing

countries .The Generalized System of Preferences (GSP) is one such system which is
currently prevailing.
(h) Bound Tariff : A bound tariff is a tariff which a WTO member binds itself with a
legal commitment not to raise it above a certain level. By binding a tariff, often during
negotiations, the members agree to limit their right to set tariff levels beyond a certain
level. The bound rates are specific to individual products and represent the maximum
level of import duty that can be levied on a product imported by that member. A member
is always free to impose a tariff that is lower than the bound level. Once bound, a tariff
rate becomes permanent and a member can only increase its level after negotiating with
its trading partners and compensating them for possible losses of trade. A bound tariff
ensures transparency and predictability.
(i) Applied Tariffs: An 'applied tariff' is the duty that is actually charged on imports
on a most-favoured nation (MFN) basis. A WTO member can have an applied tariff for a
product that differs from the bound tariff for that product as long as the applied level is
not higher than the bound level.
(j) Escalated Tariff structure refers to the system wherein the nominal tariff rates
on imports of manufactured goods are higher than the nominal tariff rates on
intermediate inputs and raw materials, i.e the tariff on a product increases as that product moves
through the value-added chain. For example a four percent tariff on iron ore or iron ingots and
twelve percent tariff on steel pipes. This type of tariff is discriminatory as it protects
manufacturing industries in importing countries and dampens the attempts of developing
manufacturing industries of exporting countries. This has special relevance to trade between
developed countries and developing countries. Developing countries are thus forced to continue
to be suppliers of raw materials without much value addition.

(k) Prohibitive tariff : A prohibitive tariff is one that is set so high that no imports
will enter.
(l) Important subsidies : In some countries, import subsidies also exist. An import
subsidy is simply a payment per unit or as a percent of value for the importation of a
good (i.e., a negative import tariff).
(m) Tariffs as Response to Trade Distortions: Sometimes countries engage in

'unfair' foreign-trade practices which are trade distorting in nature and adverse to the
interests of the domestic firms. The affected importing countries, upon confirmation of
the distortion, respond quickly by measures in the form of tariff responses to offset the
distortion. These policies are often referred to as "trigger-price" mechanisms. The
following sections relate to such tariff responses to distortions related to foreign dumping
and export subsidies
(i) Anti-dumping Duties: Dumping occurs when manufacturers sell goods in a

foreign country below the sales prices in their domestic market or below their full
average cost of the product. Dumping may be persistent, seasonal, or cyclical. Dumping
may also be resorted to as a predatory pricing practice to drive out established domestic
producers from the market and to establish monopoly position. Dumping is an
international price discrimination favouring buyers of exports, but in fact, the exporters
deliberately forego money in order to harm the domestic producers of the importing
country. This is unfair and constitutes a threat to domestic producers and therefore when
dumping is found, anti-dumping measures which are tariffs to offset the effects of
dumping may be initiated as a safeguard instrument by imposition of additional import
duties so as to offset the foreign firm's unfair price advantage. This is justified only if the
domestic industry is seriously injured by import competition, and protection is in the
national interest (that is, the associated costs to consumers would be less than the benefits
that would accrue to producers). For example: In January 2017, India imposed anti-
dumping duties on colour-coated or pre-painted flat steel products imported into the

country from China and European nations for a period not exceeding six months and for
jute and jute products from Bangladesh and Nepal.
(ii) Countervailing Duties: Countervailing duties are tariffs that aim to offset the
artificially low prices charged by exporters who enjoy export subsidies and tax
concessions offered by the governments in their home country. If a foreign country does
not have a comparative advantage in a particular good and a government subsidy allows
the foreign firm to be an exporter of the product, then the subsidy generates a distortion
from the free-trade allocation of resources. In such cases, CVD is charged in an importing
country to negate the advantage that exporters get from subsidies to ensure fair and
market oriented pricing of imported products and thereby protecting domestic industries
and firms. For example, in 2016, in order to protect its domestic industry, India imposed
12.5% countervailing duty on Gold jewellery imports from ASEAN.
Economic Effects of Tariffs
A tariff levied on an imported product affects both the country exporting a product and
the country importing that product.
(i) Tariff barriers create obstacles to trade, decrease the volume of imports and
exports and therefore of international trade. The prospect of market access of the
exporting country is worsened when an importing country imposes a tariff.
(ii) By making imported goods more expensive, tariffs discourage domestic

consumers from consuming imported foreign goods. Domestic consumers suffer a loss in
consumer surplus because they must now pay a higher price for the good and also
because compared to free trade quantity, they now consume lesser quantity of the good.
(iii) Tariffs encourage consumption and production of the domestically produced

import substitutes and thus protect domestic industries.

(iv) Producers in the importing country experience an increase in well-being as a
result of imposition of tariff. The price increase of their product in the domestic market
increases producer surplus in the industry. They can also charge higher prices than would
be possible in the case of free trade because foreign competition has reduced.
(v) The price increase also induces an increase in the output of the existing firms and
possibly addition of new firms due to entry into the industry to take advantage of the new
high profits and consequently an increase in employment in the industry.
(vi) Tariffs create trade distortions by disregarding comparative advantage and

prevent countries from enjoying gains from trade arising from comparative advantage.
Thus, tariffs discourage efficient production in the rest of the world and encourage
inefficient production in the home country.
(vii) Tariffs increase government revenues of the importing country by the value of the
total tariff it charges.
Trade liberalization in recent decades, either through government policy measures or

through negotiated reduction through the WTO or regional and bilateral free trade
agreements, has diminished the importance of tariff as a tool of protection. Currently,
trade policy is focusing increasingly on not so easily observable forms of trade barriers
usually called nontariff measures (NTMs). NTMs are thought to have important
restrictive and distortionary effects on international trade. They have become so invasive
that the benefits due to tariff reduction are practically offset by them.
NON -TARIFF MEASURES (NTMS)
From the discussion above, we have learnt that tariffs constitute the visible barriers to
trade and have the effect of increasing the prices of imported merchandise. By contrast,
the non - tariff measures which have come into greater prominence than the conventional
tariff barriers, constitute the hidden or 'invisible' measures that interfere with free trade.

Non-tariff measures (NTMs) are policy measures, other than ordinary customs tariffs,
that can potentially have an economic effect on international trade in goods, changing
quantities traded, or prices or both (UNCTAD, 2010). Non-tariff measures comprise all
types of measures which alter the conditions of international trade, including policies and
regulations that restrict trade and those that facilitate it. It should be kept in mind that
NTMs are not the same as non-tariff barriers (NTBs).
Compared to non-tariff barriers which are simply discriminatory non- tariff measures
imposed by governments to favour domestic over foreign suppliers, non-tariff measures
encompass a broader set of measures.
According to WTO agreements, the use of NTMs is allowed under certain circumstances.
Examples of this include the Technical Barriers to Trade (TBT) Agreement and the
Sanitary and Phytosanitary Measures (SPS) Agreement, both negotiated during the
Uruguay Round. However, NTMs are sometimes used as a means to circumvent free-
trade rules and favour domestic industries at the expense of foreign competition. In this
case they are called non-tariff barriers (NTBs). It is very difficult, and sometimes
impossible, to distinguish legitimate NTMs from protectionist NTMs, especially as the
same measure may be used for several reasons.
Depending on their scope and/or design NTMs are categorized as:
I. Technical Measures: Technical measures refer to product-specific properties such

as characteristics of the product, technical specifications and production processes. These
measures are intended for ensuring product quality, food safety, environmental
protection, national security and protection of animal and plant health.

II. Non-technical Measures: Non-technical measures relate to trade requirements; for
example; shipping requirements, custom formalities, trade rules, taxation policies, etc.
These are further distinguished as:
(a) Hard measures (e.g. Price and quantity control measures),
(b) Threat measures (e.g. Anti-dumping and safeguards) and
(c) Other measures such as trade-related finance and investment measures.

Furthermore, the categorization also distinguishes between:
(i) Import-related measures which relate to measures imposed by the importing

country, and
(ii) Export-related measures which relate to measures imposed by the exporting

country itself.
(iii) In addition, to these, there are procedural obstacles (PO) which are practical
problems in administration, transportation, delays in testing, certification etc that may
make it difficult for businesses to adhere to a given regulation.
Technical Measures
I Sanitary and Phytosanitary (SPS) Measures: SPS measures are applied to protect
human, animal or plant life from risks arising from additives, pests, contaminants, toxins
or disease-causing organisms and to protect biodiversity.
These include ban or prohibition of import of certain goods, all measures governing
quality and hygienic requirements, production processes, and associated compliance
assessments. For example; prohibition of import of poultry from countries affected by

avian flu, meat and poultry processing standards to reduce pathogens, residue limits for
pesticides in foods etc.
II Technical Barriers To Trade (TBT): Technical Barriers to Trade (TBT) which

cover both food and non-food traded products refer to mandatory ‗Standards and
Technical Regulations‘ that define the specific characteristics that a product should have,
such as its size, shape, design, labelling / marking / packaging, functionality or
performance and production methods, excluding measures covered by the SPS
Agreement. The specific procedures used to check whether a product is really
conforming to these requirements (conformity assessment procedures e.g. testing,
inspection and certification) are also covered in TBT. This involves compulsory quality,
quantity and price control of goods before shipment from the exporting country. Just as
SPS, TBT measures are standards-based measures that countries use to protect their
consumers and preserve natural resources, but these can also be used effectively as
obstacles to imports or to discriminate against imports and protect domestic products.
Altering products and production processes to comply with the diverse requirements in
export markets may be either impossible for the exporting country or would obviously
raise costs hurting the competitiveness of the exporting country. Some examples of TBT
are: food laws, quality standards, industrial standards, organic certification, eco-labeling,
marketing and label requirements.
Non-technical Measures
These include different types of trade protective measures which are put into operation to
neutralize the possible adverse effects of imports in the market of the importing country.
Following are the most commonly practiced measures in respect of imports:
(i) Import Quotas: An import quota is a direct restriction which specifies that only a
certain physical amount of the good will be allowed into the country during a given time
period, usually one year. Import quotas are typically set below the free trade level of

imports and are usually enforced by issuing licenses. This is referred to as a binding
quota; a non-binding quota is a quota that is set at or above the free trade level of imports,
thus having little effect on trade.
Import quotas are mainly of two types: absolute quotas and tariff-rate quotas. Absolute
quotas or quotas of a permanent nature limit the quantity of imports to a specified level
during a specified period of time and the imports can take place any time of the year. No
condition is attached to the country of origin of the product. For example: 1000 tonnes of
fish import of which can take place any time of the year from any country. When country
allocation is specified, a fixed volume or value of the product must originate in one or
more countries. Example: A quota of 1000 tonnes of fish that can be imported any time
of the year, but where 750 tonnes must originate in country A and 250 tonnes in country
B. In addition, there are seasonal quotas and temporary quotas.
With a quota, the government, of course, receives no revenue. The profits received by the
holders of such import licenses are known as ‗quota rents‘. While tariffs directly interfere
with prices that can be charged for an imported good in the domestic market, import
quota interferes with the market prices indirectly. Obviously, an import quota at all times
raises the domestic price of the imported good. The license holders are able to buy
imports and resell them at a higher price in the domestic market and they will be able to
earn a ‗rent‘ on their operations over and above the profit they would have made in a free
market.
The welfare effects of quotas are similar to that of tariffs. If a quota is set below free
trade level, the amount of imports will be reduced. A reduction in imports will lower the
supply of the good in the domestic market and raise the domestic price. Consumers of the
product in the importing country will be worse-off because the increase in the domestic
price of both imported goods and the domestic substitutes reduces consumer surplus in
the market. Producers in the importing country are better-off as a result of the quota. The
increase in the price of their product increases producer surplus in the industry. The price

increase also induces an increase in output of existing firms (and perhaps the addition of
new firms), an increase in employment, and an increase in profit.
(ii) Price Control Measures : Price control measures (including additional taxes and
charges) are steps taken to control or influence the prices of imported goods in order to
support the domestic price of certain products when the import prices of these goods are
lower. These are also known as 'para-tariff' measures and include measures, other than
tariff measures, that increase the cost of imports in a similar manner, i.e. by a fixed
percentage or by a fixed amount. Example: A minimum import price established for
sulphur.
(iii) Non-automatic Licensing and Prohibitions : These measures are normally

aimed at limiting the quantity of goods that can be imported, regardless of whether they
originate from different sources or from one particular supplier. These measures may take
the form of non-automatic licensing, or through complete prohibitions. For example,
textiles may be allowed only on a discretionary license by the importing country. India
prohibits import/export of arms and related material from/to Iraq. Also, India prohibits
many items (mostly of animal origin) falling under 60 EXIM codes.
(iv) Financial Measures: The objective of financial measures is to increase import

costs by regulating the access to and cost of foreign exchange for imports and to define
the terms of payment. It includes measures such as advance payment requirements and
foreign exchange controls denying the use of foreign exchange for certain types of
imports or for goods imported from certain countries. For example, an importer may be
required to pay a certain percentage of the value of goods imported three months before
the arrival of goods or foreign exchange may not be permitted for import of newsprint.
(v) Measures Affecting Competition: These measures are aimed at granting

exclusive or special preferences or privileges to one or a few limited group of economic
operators. It may include government imposed special import channels or enterprises, and
compulsory use of national services. For example, a statutory marketing board may be

granted exclusive rights to import wheat: or a canalizing agency (like State Trading
Corporation) may be given monopoly right to distribute palm oil. When a state agency or
a monopoly import agency sells on the domestic market at prices above those on the
world market, the effect will be similar to an import tariff.
(vi) Government Procurement Policies: Government procurement policies may

interfere with trade if they involve mandates that the whole of a specified percentage of
government purchases should be from domestic firms rather than foreign firms, despite
higher prices than similar foreign suppliers. In accepting public tenders, a government
may give preference to the local tenders rather than foreign tenders.
(vii) Trade-Related Investment Measures: These measures include rules on local

content requirements that mandate a specified fraction of a final good should be produced
domestically.
(a) requirement to use certain minimum levels of locally made components, ( 25

percent of components of automobiles to be sourced domestically)
(b) restricting the level of imported components , and
(c) limiting the purchase or use of imported products to an amount related to the
quantity or value of local products that it exports. ( A firm may import only up to 75 % of
its export earnings of the previous year)
(viii) Distribution Restrictions: Distribution restrictions are limitations imposed on

the distribution of goods in the importing country involving additional license or
certification requirements. These may relate to geographical restrictions or restrictions as
to the type of agents who may resell. For example: a restriction that imported fruits may
be sold only through outlets having refrigeration facilities

(ix) Restriction on Post-sales Services: Producers may be restricted from providing
after- sales services for exported goods in the importing country. Such services may be
reserved to local service companies of the importing country.
(x) Administrative Procedures : Another potential obstruction to free trade is the

costly and time consuming administrative procedures which are mandatory for import of
foreign goods. These will increase transaction costs and discourage imports. The
domestic import-competing industries gain by such non- tariff measures. Examples
include specifying particular procedures and formalities, requiring licenses,
administrative delay, red-tape and corruption in customs clearing frustrating the potential
importers , procedural obstacles linked to prove compliance etc.
(xi) Rules of origin: Rules of origin are the criteria needed by governments of
importing countries to determine the national source of a product. Their importance is
derived from the fact that duties and restrictions in several cases depend upon the source
of imports. Important procedural obstacles occur in the home countries for making
available certifications regarding origin of goods, especially when different components
of the product originate in different countries.
(xii) Safeguard Measures are initiated by countries to restrict imports of a product

temporarily if its domestic industry is injured or threatened with serious injury caused by
a surge in imports.
(xiii) Embargos : An embargo is a total ban imposed by government on import or

export of some or all commodities to particular country or regions for a specified
or indefinite period. This may be done due to political reasons or for other reasons such
as health, religious sentiments. This is the most extreme form of trade barrier
EXPORT-RELATED MEASURES

(i) Ban on exports : Export-related measures refer to all measures applied by the
government of the exporting country including both technical and non-technical
measures. For example ,during periods of shortages, export of agricultural products such
as onion , wheat etc may be prohibited to make them available for domestic consumption.
Export restrictions have an important effect on international markets. By reducing
international supply, export restrictions have been shown to increase international prices.
(ii) Export Taxes: An export tax is a tax collected on exported goods and may be
either specific or ad valorem. The effect of an export tax is to raise the price of the good
and to decrease exports. Since an export tax reduces exports and increases domestic
supply, it also reduces domestic prices and leads to higher domestic consumption.
(iii) Export Subsidies and Incentives : We have seen that tariffs on imports hurt
exports and therefore countries have developed compensatory measures of different types
for exporters like export subsidies ,duty drawback, duty-free access to imported
intermediates etc. Governments or government bodies also usually provide financial
contribution to domestic producers in the form of grants, loans, equity infusions etc. or
give some form of income or price support. If such policies on the part of governments
are directed at encouraging domestic industries to sell specified products or services
abroad, they can be considered as trade policy tools.
(iv) Voluntary Export Restraints : Voluntary Export Restraints (VERs) refer to a

type of informal quota administered by an exporting country voluntarily restraining the
quantity of goods that can be exported out of that country during a specified period of
time. Such restraints originate primarily from political considerations and are imposed
based on negotiations of the importer with the exporter. The inducement for the exporter
to agree to a VER is mostly to appease the importing country and to avoid the effects of
possible retaliatory trade restraints that may be imposed by the importer. VERs may arise
when the import-competing industries seek protection from a surge of imports from
particular exporting countries. VERs cause, as do tariffs and quotas, domestic prices to
rise and cause loss of domestic consumer surplus.

Over the past few decades, significant transformations are happening in terms of growth
as well as trends of flows and patterns of global trade. The increasing importance of
developing countries has been a salient feature of the shifting global trade patterns.
Fundamental changes are taking place in the way countries associate themselves for
international trade and investments. Trading through regional arrangements which foster
closer trade and economic relations is shaping the global trade landscape in an
unprecedented way. Alongside, the trading countries also have devised ingenious policies
aimed at protecting their economic interests. The discussions in this unit are in no way
comprehensive considering the faster pace of discovery of such protective strategies.
Students are expected to get themselves updated on such ongoing changes.
Module 3
INTRODUCTION
In unit one, our focus was on international trade in goods and services. of late, we find
enormous increase in international movement of capital. This phenomenon has received a
great deal of attention from not just economists and policy-makers but people in different
walks of life including workers‘ organisations and members of the civil society. In this
unit, we shall look into international capital movements; more precisely into why do
capital move across national boundaries and what are the consequences of such capital
movements. We shall also briefly touch upon the FDI situation in India.
TYPES OF FOREIGN CAPITAL

The term 'foreign capital' is a comprehensive one and includes any inflow of capital into
the home country from abroad and therefore, we need to be clear about the distinction
between movement of capital and foreign investment. Foreign capital may flow into an
economy in different ways. Some of the important components of foreign capital flows
are:
1. Foreign aid or assistance which may be:
(a) Bilateral or direct inter government grants
(b) Multilateral aid from many governments who pool funds to international
organizations like the World Bank
(c) Tied aid with strict mandates regarding the use of money or untied aid where
there are no such stipulations
(d) Foreign grants which are voluntary transfer of resources by governments,

institutions, agencies or organizations
2. Borrowings which may take different forms such as:
(a) Direct inter government loans
(b) Loans from international institutions (e.g. world bank, IMF, ADB)
(c) Soft loans for e.g. from affiliates of World Bank such as IDA
(d) External commercial borrowing, and
(e) Trade credit facilities

3. Deposits from non-resident Indians (NRI)
4. Investments in the form of :
(i) Foreign portfolio investment (FPI) in bonds, stocks and securities, and
(ii) Foreign direct investment(FDI) in industrial, commercial and similar other

enterprises
A detailed discussion about all types of capital movements is beyond the scope of this
unit and therefore, we shall concentrate only on foreign investments.
FOREIGN DIRECT INVESTMENT (FDI )
When we talk about international investments, we should first of all distinguish between two
types of investments namely, Foreign Direct Investment (FDI) and Foreign Portfolio Investment
(FPI). Foreign direct investment is defined as a process whereby the resident of one country (i.e.
home country) acquires ownership of an asset in another country (i.e. the host country) and such
movement of capital involves ownership, control as well as management of the asset in the host
country. Foreign direct investment (FDI), according to IMF manual on 'Balance of payments' is
"all investments involving a long term relationship and reflecting a lasting interest and control of
a resident entity in one economy in an enterprise resident in an economy other than that of the
direct investor‖. This typically occurs through acquisition of more than 10 percent of the shares
of the target asset. Direct investment comprises not only the initial transaction establishing the
relationship between the investor and the enterprise, but also all subsequent transactions between
them and among affiliated enterprises, both incorporated and unincorporated.
According to the IMF and OECD definitions, the acquisition of at least ten percent of the
ordinary shares or voting power in a public or private enterprise by non-resident investors makes

it eligible to be categorized as foreign direct investment (FDI). India also follows the same
pattern of classification. FDI has three components, viz., equity capital, reinvested earnings and
other direct capital in the form of intra-company loans between direct investors (parent
enterprises) and affiliate enterprises.
Foreign direct investors may be individuals, incorporated or unincorporated private or public

enterprises, associated groups of individuals or enterprises, governments or government
agencies, estates, trusts, or other organizations or any combination of the above mentioned
entities. The main forms of direct investments are: the opening of overseas companies, including
the establishment of subsidiaries or branches, creation of joint ventures on a contract basis, joint
development of natural resources and purchase or annexation of companies in the country
receiving foreign capital.
Direct investments are real investments in factories, assets, land, inventories etc. and involve
foreign ownership of production facilities. The investor retains control over the use of the
invested capital and also seeks the power to exercise control over decision making to the extent
of its equity participation. The lasting interest implies the existence of a long-term relationship
between the direct investor and the enterprise and a significant degree of influence by the
investor on the management of the enterprise.
Based on the nature of foreign investments, FDI may be categorized as horizontal,

vertical or conglomerate.
i) A horizontal direct investment is said to take place when the investor establishes
the same type of business operation in a foreign country as it operates in its home
country, for example, a cell phone service provider based in the United States moving to
India to provide the same service.
ii) A vertical investment is one under which the investor establishes or acquires a
business activity in a foreign country which is different from the investor‘s main business
activity yet in some way supplements its major activity. For example; an automobile

manufacturing company may acquire an interest in a foreign company that supplies parts
or raw materials required for the company.
iii) A conglomerate type of foreign direct investment is one where an investor makes
a foreign investment in a business that is unrelated to its existing
business in its home country. This is often in the form of a joint venture with a foreign
firm already operating in the industry as the investor has no previous experience.
Yet another category of investments is ‗two - way direct foreign investments‘ which are
reciprocal investments between countries that occur when some industries are more
advanced in one nation (for example, the computer industry in the United States), while
other industries are more efficient in other nations (such as the automobile industry in
Japan).
FOREIGN PORTFOLIO INVESTMENT (FPI)
Foreign portfolio investment is the flow of what economists call ‗financial capital‘ rather
than ‗real capital‘ and does not involve ownership or control on the part of the investor.
Examples of foreign portfolio investment are the deposit of funds in an Indian or a British
bank by an Italian company or the purchase of a bond (a certificate of indebtedness) of a
Swiss company or of the Swiss government by a citizen or company based in France.
Unlike FDI, portfolio capital, in general, moves to investment in financial stocks, bonds
and other financial instruments and is effected largely by individuals and institutions
through the mechanism of capital market. These flows of financial capital have their
immediate effects on balance of payments or exchange rates rather than on production or
income generation.
Foreign portfolio investment (FPI) is not concerned with either manufacture of goods or
with provision of services. Such investors also do not have any intention of exercising
voting power or controlling or managing the affairs of the company in whose securities
they invest. The singular intention of a foreign portfolio investor is to earn a remunerative

return through investment in foreign securities and is primarily concerned about the
safety of their capital, the likelihood of appreciation in its value, and the return generated.
Logically, portfolio capital moves to a recipient country which has revealed its potential
for higher returns and profitability.
Following international standards, portfolio investments are characterised by lower stake

in companies with their total stake in a firm at below 10 percent. It is also noteworthy that
unlike the FDIs, these investments are typically of short term nature, and therefore, are
not intended to enhance the productive capacity of an economy by the creation of capital
assets.
Portfolio investors will evaluate, on a separate basis, the prospects of each independent
unit in which they might invest and may often shift their capital with changes in these
prospects. Therefore, portfolio investments are, to a large extent, expected to be
speculative. Once investor confidence is shaken, such capital has a tendency to speedily
shift from one country to another, occasionally creating financial crisis for the host
country.
Table 4.5.1
Foreign direct investment (FDI) Foreign portfolio investment (FPI)
Investment involves creation of Investment is only in financial assets
physical assets
Has a long term interest and Only short term interest and generally
therefore remain invested for long remain invested for short periods
Relatively difficult to withdraw Relatively easy to withdraw

Not inclined to be speculative Speculative in nature
Often accompanied by technology Not accompanied by technology transfer
transfer
Direct impact on employment of No direct impact on employment of labour

labour and wages and wages
Enduring interest in management No abiding interest in management and

and control control
Securities are held with Securities are held purely as a
significant degree of influence financial investment and no
by the investor onthe management significant degree of influence on
of the enterprise the management of the
enterprise
REASONS FOR FOREIGN DIRECT INVESTMENT
As we know, economic prosperity and the relative abundance of capital are necessary
prerequisites for export of capital to other countries. Many economies and organisations
have accumulation of huge mass of reserve capital seeking profitable use. The primary
aim of economic agents being maximisation of their economic interests, the opportunity
to generate profits available in other countries often entices such entities to make
investments in other countries. The chief motive for shifting of capital between different
regions or between different industries is the expectation of higher rate of return than
what is possible in the home country. Investment in a host country may be found
profitable by foreign firms because of some firm -specific knowledge or assets (such as
superior management skills or an important patent) that enable the foreign firm to

gainfully outperform the host country's domestic firms. There are many other reasons (as
listed below) for international capital movements which have found adequate empirical
support. Investments move across borders on account of:
(i) the increasing interdependence of national economies and the consequent trade
relations and international industrial cooperation established among them
(ii) internationalisation of production and investment of transnational corporations in

their subsidiaries and affiliates.
(iii) desire to reap economies of large-scale operation arising from technological

growth
(iv) lack of feasibility of licensing agreements with foreign producers in view of the
rapid rate of technological innovations
(v) necessity to retain direct control of production knowledge or managerial skill

(usually found in monopolistic or oligopolistic markets) that could easily and profitably
be utilized by corporations
(vi) desire to procure a promising foreign firm to avoid future competition and the
possible loss of export markets
(vii) risk diversification so that recessions or downturns may be experienced with

reduced severity
(viii) shared common language or common boundaries and possible saving in time and
transport costs because of geographical proximity
(ix) necessity to retain complete control over its trade patents and to ensure

consistent quality and service or for creating monopolies in a global context
(x) promoting optimal utilization of physical, human, financial and other resources
(xi) desire to capture large and rapidly growing high potential emerging markets
with substantially high and growing population
(xii) ease of penetration into the markets of those countries that have established
import restrictions such as blanket bans, high customs duties or non-tariff barriers which
make it difficult for the foreign firm to sell in the host-country market by ‗getting behind
the tariff wall‘.
(xiii) lower environmental standards in the host country and the consequent relative
savings in costs
(xiv) stable political environment and overall favourable investment climate in the host
country
(xv) higher degree of openness to foreign capital exhibited by the recipient country and
the prevalence of preferential investment systems such as special economic zones to
encourage direct foreign investments
(xvi) the strategy to obtain control of strategic raw material or resource so as to ensure
their uninterrupted supply at the lowest possible price; usually a form of vertical
integration
(xvii) desire to secure access to minerals or raw material deposits located

elsewhere and earn profits through processing them to finished form (Eg.FDI in
petroleum)

(xviii) the existence of low relative wages in the host country because of relative labour
abundance coupled with shortage and high cost of labour in capital exporting countries,
especially when the production process is labour intensive.
(xix) lower level of economic efficiency in host countries and identifiable gaps in
development
(xx) tax differentials and tax policies of the host country which support direct
investment. However, a low tax burden cannot compensate for a generally fragile and
unattractive FDI environment
(xxi) inevitability of defensive investments in order to preserve a firm‘s competitive

position
(xxii) high gross domestic product and high per capita income coupled with their high
rate of growth . There are also other philanthropic objectives such as strengthening of
socio-economic infrastructure, alleviation of poverty and maintenance of ecological
balance of the host country ,and
(xxiii) prevalence of high standards of social amenities and possibility of good quality of
life in the host country
Table 4.5.2 Host Country Determinants of Foreign Direct Investment

Economic Determinants Policy Framework
Market -seeking FDI: Economic, political, and social stability

Market size and per capita income Rules regarding entry and operations
Market growth Standards of treatment of foreignaffiliates
Access to regional and global markets Policies on functioning and structure of
Country-specific consumer preferences markets (e.g., regarding competition,

Structure of markets mergers)
Resource - or asset-seeking FDI: International agreements on FDI
Raw materials Privatization policy
Low -cost unskilled labour Trade policies and coherence of FDI and
Availability of skilled labour trade policies
Technological, innovative, and Tax policy
othercreated assets (e.g., brand names) Business Facilitation
Physical infrastructure Investment promotion (including image
building and investment-generating
activities and investment-facilitation
services)
Efficiency -seeking FDI:
Costs of above physical and Investment incentives
humanresources and assets(including an "Hassle costs" (related to corruption and
adjustment for productivity) administrative efficiency)
Other input costs (e.g., intermediate Social amenities (e.g., bilingual schools,
products, transport costs) quality of life)
Membership of country in a regional After-investment services
integration agreement, which could be
conducive to forming regional corporate
networks
Source :International economics (7th ed) International Economics, Dennis R. Appleyard;

Alfred J. Field; Steven L. Cobb(P237)
Factors in the host country discouraging inflow of foreign investments are infrastructure
lags, high rates of inflation, balance of payment deficits, poor literacy and low labour
skills, rigidity in the labour market, bureaucracy and corruption, unfavourable tax regime,
cumbersome legal formalities and delays, small size of market and lack of potential for
its growth, political instability, absence of well-defined property rights, exchange rate
volatility, poor track -record of investments, prevalence of non-tariff barriers, stringent

regulations, lack of openness, language barriers, high rates of industrial disputes, lack of
security to life and property, lack of facilities for immigration and employment of foreign
technical and administrative personnel, double taxation and lack of a general spirit of
friendliness towards foreign investors.
MODES OF FOREIGN DIRECT INVESTMENT (FDI)
Foreign direct investments can be made in a variety of ways, such as:
(i) Opening of a subsidiary or associate company in a foreign country,
(ii) Equity injection into an overseas company,
(iii) Acquiring a controlling interest in an existing foreign company,
(iv) Mergers and acquisitions(M&A)
(v) Joint venture with a foreign company.
(vi) Green field investment (establishment of a new overseas affiliate for freshly
starting production by a parent company).
BENEFITS OF FOREIGN DIRECT INVESTMENT
The benefits from and concerns about FDI are widely discussed and well documented.
While recognizing the fact that there are also benefits and costs to the home country from
capital outflow, in this unit we focus only on host-country effects of FDI with particular
attention to the developing countries. Following are the benefits ascribed to foreign
investments:

1. Entry of foreign enterprises usually fosters competition and generates a
competitive environment in the host country. The domestic enterprises are compelled to
compete with the foreign enterprises operating in the domestic market. This results in
positive outcomes in the form of cost-reducing and quality-improving innovations, higher
efficiency and increasing variety of better products and services at lower prices ensuring
wider choice and welfare for consumers
2. International capital allows countries to finance more investment than can be

supported by domestic savings. The provision of increased capital to work with labour
and other resources available in the host country can enhance the total output (as well as
output per unit of input) flowing from the factors of production.
3. From the perspective of emerging and developing countries, FDI can accelerate
growth and foster economic development by providing the much needed capital,
technological know-how, management skills and marketing methods and critical human
capital skills in the form of managers and technicians. The spill-over effects of the new
technologies usually spread beyond the foreign corporations. In addition, the new
technology can clearly enhance the recipient country's production possibilities.
4. Competition for FDI among national governments also has helped to promote
political reforms important to attract foreign investors, including legal systems and
macroeconomic policies.
5. Since FDI involves setting up of production base (in terms of factories, power
plants, etc.) it generates direct employment in the recipient country. Subsequent FDI as
well as domestic investments propelled in the downstream and upstream projects that
come up in multitude of other services generate multiplier effects on employment and
income.
6. FDI not only creates direct employment opportunities but also, through backward
and forward linkages, generate indirect employment opportunities

This impact is particularly important if the recipient country is a developing country with
an excess supply of labour caused by population pressure.
7. Foreign direct investments also promote relatively higher wages for skilled jobs.
More indirect employment will be generated to persons in the lower-end services sector
occupations thereby catering to an extent even to the less educated and unskilled persons
engaged in those units.
8. Foreign corporations provide better access to foreign markets. Unlike portfolio

investments, FDI generally entails people-to-people relations and is usually considered as
a promoter of bilateral and international relations. Greater openness to foreign capital
leads to higher national dependence on international investors, making the cost of
discords higher.
9. There is also greater possibility for the promotion of ancillary units resulting in
job creation and skill development for workers.
10. Foreign enterprises possessing marketing information with their global network of
marketing are in a unique position to utilize these strengths to promote the exports of
developing countries. If the foreign capital produces goods with export potential, the host
country is in a position to secure scarce foreign exchange which can be used to import
needed capital equipments or materials to assist the country's development plans or to
ease its external debt servicing.
11. If the host country is in a position to implement effective tax measures, the
foreign investment projects also would act as a source of new tax revenue which can be
used for development projects.
12. It is likely that foreign investments enter into industries in which scale economies
can be realized so that consumer prices might be lowered. Domestic firms might not

always be able to generate the necessary capital to achieve the cost reductions associated
with large-scale production.
13. Increased competition resulting from the inflow of foreign direct investments
facilitates weakening of the market power of domestic monopolies resulting in a possible
increase in output and fall in prices.
14. Since FDI has a distinct advantage over the external borrowings, it is considered
to have a favourable impact on the host country‘s balance of payment position, and
15. Better work culture and higher productivity standards brought in by foreign firms
may possibly induce productivity related awareness and may also contribute to overall
human resources development.
POTENTIAL PROBLEMS ASSOCIATED WITH FOREIGN DIRECT

INVESTMENT
In the above section, we have seen that a wide variety of benefits may result from an
inflow of foreign direct investment. These gains do not occur in all cases, nor do they
occur in the same magnitude. Despite the arguments which vehemently favour direct
investments in host countries, many are highly critical of the impact of foreign capital,
especially on developing economies. They argue that foreign entities are highly focused
on profits and have an eye on exploiting the natural resources and are almost always not
genuinely interested in the development needs of host countries. Foreign capital is
perceived by the critics as an instrument of imperialism, or as a perpetrator of
dependence and inequality both
between nations and within nations.
Following are the general arguments put forth against the entry of foreign capital.
1. FDIs are likely to concentrate on capital-intensive methods of production and

service so that they need to hire only relatively few workers. Such technology is

inappropriate for a labour-abundant country as it does not support generation of jobs
which is a crucial requirement to address poverty and unemployment which are the two
fundamental areas of concern for the less developed countries.
2. The inherent tendency of FDI flows to move towards regions or states which are
well endowed in terms of natural resources and availability of infrastructure has the
potential to accentuate regional disparity. Foreign capital is also
criticized for accentuating the already existing income inequalities in the host country.
3. In the context of developing countries, it is usually alleged that the inflow of

foreign capital may cause the domestic governments to slow down its efforts to generate
more domestic savings, especially when tax mechanisms are difficult to implement. If the
foreign corporations are able to secure incentives in the form of tax holidays or similar
provisions, the host country loses tax revenues.
4. Often, the foreign firms may partly finance their domestic investments by
borrowing funds in the host country's capital market. This action can raise interest rates in
the host country and lead to a decline in domestic investments through ‗crowding-out‘
effect. Moreover, suppliers of funds in developing economies would prefer foreign firms
due to perceived lower risks and such shifts of funds may divert capital away from
investments which are crucial for the development needs of the country.
5. The expected benefits from easing of the balance of payments situation might
remain unrealised or narrowed down due to the likely instability in the balance
of payments and the exchange rate. Obviously, FDI brings in more foreign exchange,
improves the balance of payments and raises the value of the host country's currency in
the exchange markets. However, when imported inputs need to be obtained or when
profits are repatriated, a strain is placed on the host country's balance of payments and the
home currency leading to its depreciation. Such instabilities jeopardize long- term
economic planning. Foreign corporations also have a tendency to use their usual input

suppliers which can lead to increased imports. Also, large scale repatriation of profits can
be stressful on the balance of payments.
6. Jobs that require expertise and entrepreneurial skills for creative decision making
may generally be retained in the home country and therefore the host country is left with
routine management jobs that demand only lower levels of skills and ability. The
argument of possible human resource development and acquisition of new innovative
skills through FDI may not be realized in reality.
7. High profit orientation of foreign direct investors tend to promote a distorted

pattern of production and investment such that production could get concentrated on
items of elite and popular consumption and on non-essential items.
8. Foreign entities are usually accused of being anti-ethical as they frequently resort
to methods like aggressive advertising and anticompetitive practices which would induce
market distortions.
9. A large foreign firm with deep pockets may undercut a competitive local industry
because of various advantages (such as in technology) possessed by
it and may even drive out domestic firms from the industry resulting in serious problems
of displacement of labour. The foreign firms may also exercise a high degree of market
power and exist as monopolists with all the accompanying disadvantages of monopoly.
The high growth of wages in foreign corporations can influence a similar escalation in the
domestic corporations which are not able to cover this increase with growth of
productivity. The result is decreasing competitiveness of domestic companies which
might prove detrimental to the long term interests of industrial development of the host
country.
10. FDI usually involves domestic companies ‗off –shoring‘, or shifting jobs and
operations abroad in pursuit of lower operating costs and consequent higher profits. This
has deleterious effects on employment potential of home country.

11. The continuance of lower labour or environmental standards in host countries is
highly appreciated by the profit seeking foreign enterprises. This is of great concern
because efforts to converge such standards often fail to receive support from interested
parties.
12. At times, there is potential national security considerations involved when foreign
firms function in the territory of the host country, especially when acute hostilities
prevail.
13. FDI may have adverse impact on the host country's commodity terms of trade
(defined as the price of a country's exports divided by the price of its imports). This could
occur if the investments go into production of export goods and the country is a large
country in the sale of its exports. Thus, increased exports drive down the price of exports
relative to the price of imports.
14. FDI is also held responsible by many for ruthless exploitation of natural resources
and the possible environmental damage.
15. With substantial FDI in developing countries there emergence of a dual economy
with a developed underdeveloped domestic sector. is a strong possibility of foreign sector
and an underdeveloped domestic sector.
16. Perhaps the most disturbing of the various charges levied against foreign direct
investment is that a large foreign investment sector can exert excessive amount of power
in a variety of ways so that there is potential loss of control by host country over
domestic policies and therefore the less developed host country‘s sovereignty is put at
risk. Mighty multinational firms are often criticized of corruption issues, unduly
influencing policy making and evasion of corporate social responsibility.

No general assessment can be made regarding whether the benefits of FDI outweigh the
costs. Each country's situation and each firm's investment must be examined in the light
of various considerations and a judgment about the desirability or otherwise of the
investment should be arrived at.
Many safeguards and performance requirements are put in place by developed and
developing countries to improve the ratio of benefits to costs associated with foreign
capital. A few examples are: domestic content requirements on inputs, reservation of
certain key sectors to domestic firms, requirement of a minimum percent of local
employees, ceiling on repatriation of profits, local sourcing requirements and stipulations
for full or partial export of output to earn scarce foreign exchange.
FOREIGN DIRECT INVESTMENT IN INDIA (FDI)
The import-substitution strategy of industrialisation followed by India post independence

stressed on an extremely careful and selective approach while formulating FDI policy.
Extensive controls imposed by the government severely restricted the inflow of foreign
capital to India. The enactment of the Foreign Exchange Regulation Act (FERA), 1973
consolidated the regulatory framework with stipulations of upto 40 per cent of foreign
equity holding in a joint venture. The Industrial Policy announcements of 1980 and 1982
and the Technology Policy Statement (1983) provided for a moderately lenient attitude
towards foreign investments by endorsement of manufacturing exports as well as
modernisation of industries through liberalised imports of capital goods and technology.
This was supplemented by trade liberalisation measures in the form of tariff reduction
and shifting of large number of items from import licensing to Open General Licensing
(OGL).
The most important shift in investment policy occurred when India embarked upon
economic liberalisation and reforms programme in 1991 to raise its growth potential and

to integrate it with the world economy. Further reforms in subsequent years put in place a
series of measures directed towards liberalizing foreign investments and for ensuring
access to foreign technology and funding.
The government‘s strategy favouring foreign investments and the prevalent robust
business environment have ensured that foreign capital keeps flowing into the country.
The government initiatives such as automatic approval of FDI, simplification of
procedures, setting up of Foreign Investment Promotion Board (FIPB abolished wef May
2017), signing of the Multilateral Investment Guarantee Agency Protocol for protection
of foreign investments, permitting use of foreign trade marks and brand names, 100%
FDI in multitude of sectors , enactment of Foreign Exchange Management Act (FEMA),
passing of the SEZ Act in 2005, Special
Economic Zones (SEZ), support to mergers ,acquisitions and green field investments, and
encouragement to foreign technology collaboration agreements are a few such measures.
Apart from being a critical driver of economic growth, foreign direct investment (FDI) is
a major source of non-debt financial resource for the economic development of India.
According to United Nations Conference on Trade and Development (UNCTAD)‘s
World Investment Report 2016, India ranks as the tenth highest recipient of foreign direct
investment globally in 2015 receiving $44 billion of investment that year compared to
$35 billion in 2014. India has also moved up by one rank to become the sixth most
preferred investment destination.
According to the Department of Industrial Policy and Promotion (DIPP), the total FDI
investments India received during April - September 2016 rose 30 per cent year-on-year
to US$ 21.6 billion. During the period, the services sector attracted the highest FDI
equity inflow (US$ 5.29 billion), followed by telecommunications (US $ 2.79 billion),
and trading (US$ 1.48 billion). Also, India received the maximum FDI equity inflows
from Mauritius (US$ 5.85 billion) followed by Singapore, Netherlands, Japan and the
USA.

With the government taking steps to improve the ease of doing business and to relax
regulations, foreign direct investment into the country surged by 60 per cent to $4.68
billion in November 2016 from $2.93 billion in November 2015.
Currently, an Indian company may receive foreign direct investment either through
‗automatic route‘ without any prior approval either of the Government or the Reserve
Bank of India or through ‗government route‘ with prior approval of the Government.
An Indian Company can receive foreign investment by issue of ‗FDI compliant

instruments‘ namely: equity shares, fully and mandatorily convertible preference shares
and debentures, partly paid equity shares and warrants. These have to be issued in
accordance with the provisions of the Companies Act, 2013 and the SEBI guidelines, as
applicable.
All foreign investments are repatriable (net of applicable taxes) except in cases where the
investment is made or held on non-repatriation basis or where the sectoral condition
specifically mentions non-repatriation. Further, dividends/ profits (net of applicable
taxes), on foreign investments, being current income can be remitted outside India
through an Authorised Dealer bank. Only NRIs are allowed to set up partnership/
proprietorship concerns in India on non-repatriation basis.
In India, foreign investment is prohibited in the following sectors:
(i) Lottery business including Government / private lottery, online lotteries, etc.
(ii) Gambling and betting including casinos etc.
(iii) Chit funds
(iv) Nidhi company

(v) Trading in Transferable Development Rights (TDRs)
(vi) Real Estate Business or Construction of Farm Houses
(vii) Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or of

tobacco substitutes
(viii) Activities / sectors not open to private sector investment e.g. atomic energy and
railway operations (other than permitted activities).
Foreign technology collaboration in any form including licensing for franchise,

trademark, brand name, management contract is also prohibited for lottery business and
gambling and betting activities.
With the objective of making India the most open economy in the world for FDI and for
providing major impetus to employment and job creation, the FDI regime was radically
liberalized on 20-June-2016. Changes introduced in the FDI policy include increase in
sectoral caps, bringing more activities under automatic route and easing of conditions for
foreign investment. These include easing of FDI in defence sector, e-commerce, in
respect of food products manufactured or produced in India, pharmaceuticals (Greenfield
and Brownfield), airports (both Greenfield and Brownfield),airport transport services,
private security agencies, animal husbandry, establishment of branch offices, liaison
office or project office, teleports, direct to home cable networks, mobile TV and headend-
in-the sky broadcasting service and single brand retail trading.
OVERSEAS DIRECT INVESTMENT BY INDIAN COMPANIES
Integration of the Indian economy with the rest of the world is evident not only in terms
of higher level of FDI inflows but also in terms of increasing level of FDI outflows as
overseas investments by the Indian entrepreneurs in joint ventures (JV) and wholly

owned subsidiaries (WOS). Outbound investments from India have undergone substantial
changes not only in terms of size but also in terms of geographical spread and sectoral
composition. Outward Foreign Direct Investment (OFDI) from India stood at US$ 1.86
billion in the month of June, 2016.
The overseas investments have been primarily driven by resource seeking, market
seeking or technology seeking motives. Many Indian IT firms like Tata Consultancy
Services, Infosys, WIPRO, and Satyam acquired global contracts and established
overseas offices in developed economies to be close to their key clients. Of late, there has
been a surge in resource seeking overseas investments by Indian companies, especially to
acquire energy resources in Australia, Indonesia and Africa. Indian entrepreneurs are also
choosing investment destinations in countries such as Mauritius, Singapore, British
Virgin Islands, and the Netherlands on account of higher tax benefits they provide.
At present, any Indian investor can make overseas direct investment in any bona-fide
activity except in certain real estate activities. This has been made possible by
progressive relaxation of the capital controls and simplification of procedures for
outbound investments from India. For example, the annual overseas investment ceiling to
establish joint ventures (JV) and wholly owned subsidiaries has been raised to US$
125,000 from US$ 75,000. The RBI has also relaxed norms for foreign investment by
Indian corporates by raising the borrowing limit.
Policies in respect of foreign investments undergo far reaching changes from time to time
India’s Trade Policy

India‘s trade policy used Import restriction through a judicious use of import licensing, import
quotas, import duties and in extreme cases, even banning import of specific goods. This was
essential to protect domestic industries and promote industrial development. Mahalanobis
strategy of economic development through heavy industries, which India adopted since second
five year plan seems to have been guided the trade policy through the following:
a. Banning or keeping to minimum the import of non essential consumer goods.

b. Comprehensive control of various items of imports.
c. Liberal import of machinery, equipment and other development goods to support
heavy industry based economic growth.
d. Prosperous climate for the policy.
e. Vigorous export promotion was emphasized after the second five year plan to
earn foreign exchange to overcome the penetrating foreign exchange crisis.
f. During 1970‘s importance of export promotion was again emphasized because of
mounting debt service obligations and the goal of self reliance (with zero net aid)
Foreign Trade Policy of India

The integration of the domestic economy through the twin channels of trade and capital flows
has accelerated in the past two decades which in turn led to the Indian economy growing from Rs
32 trillion (US$ 474.37 billion) in 2004 to about Rs 153 trillion (US$ 2.3 trillion) by 2016.
Simultaneously, the per capita income also nearly trebled during these years. India‘s trade and
external sector had a significant impact on the GDP growth as well as expansion in per capita
income. Total merchandise exports from India grew by 4.48 per cent year-on-year to US$ 25.83
billion in February 2018, while merchandise trade deficit increased 25.81 per cent year-on-year
from US $ 11.979 billion during April-February 2017-18 to US $ 9.521 billion during April-
February 2017-18, according to data from the Ministry of Commerce & Industry. Capital Inflows
According to data released by the Reserve Bank of India (RBI), India's foreign exchange
reserves were US$ 421.335 billion as on March 16, 2018.
Foreign Direct Investments (FDI)

During April 2000–December 2017, India received total foreign investment (including equity
inflows, re-invested earnings and other capital) worth US$ 532.6 billion. The country was one of
the top destinations for FDI inflows from Asian countries, with Mauritius contributing 34 per
cent, Singapore 17 per cent and Japan and UK contributing 7 per cent each of the total foreign
inflows.
Foreign Institutional Investors (FIIs)
FIIs net investments in Indian equities, debt and hybrid stood at Rs 145,068 crores (US$ 22.34
billion) in 2017-18.

External Sector
India‘s external sector has a bright future as global trade is expected to grow at 4 per cent in
2018 from 2.4 per cent in 2016. Bilateral trade between India and Ghana is rising exponentially
and is expected to grow from US$ 3 billion to US$ 5 billion over the coming three years, stated
Mr Aaron Mike Oquaye Junior, Ghana's Ambassador to India.
India has revised its proposal on trade facilitation for services (TFS) at the World Trade
Organisation (WTO) and has issued a new draft, with the contents being more meaningful and
acceptable to other member countries. Indian exports of merchandise shipments is expected to
reach US$ 325 billion in 2017-18, compared to US$ 275 billion in 2016-17, as per Mr Ganesh
Kumar Gupta, President, Federation of Indian Export Organisations (FIEO). The Union Cabinet,
Government of India, has approved the proposed Memorandum of Understanding (MoU)
between Export-Import Bank of India (EXIM Bank) and Export-Import Bank of Korea
(KEXIM). The Goods and Services Network (GSTN) has signed a memorandum of
understanding (MoU) with Mr Ajay K Bhalla, Director General of Foreign Trade (DGFT), to
share realised foreign exchange and import-export code data, process export transactions of
taxpayers under goods and services tax (GST) more efficiently, increase transparency and reduce
human interface. In March 2017, the Union Cabinet approved the signing of the customs
convention on the international transport of goods, Transports Internationaux Routiers (TIR)
making India the 71st signatory to the treaty, which will enable the movement of goods
throughout these countries in Asia and Europe and will allow the country to take full benefit of
the International North South Transportation Corridor (INSTC). Mr Richard Verma, the United
States Ambassador to India, has verified that India-US relations across trade, defence and social
ties will be among the top priorities of the newly elected US President Mr Donald Trump's
administration.
Foreign Trade Policy

In the Mid-Term Review of the Foreign Trade Policy (FTP) 2015-20 the Ministry of Commerce
and Industry has enhanced the scope of Merchandise Exports from India Scheme (MEIS) and
Service Exports from India Scheme (SEIS), increased MEIS incentive raised for ready-made
garments and made- ups by 2 per cent, raised SEIS incentive by 2 per cent and increased the

validity of Duty Credit Scrips from 18 months to 24 months. All export and import-related
activities are governed by the Foreign Trade Policy (FTP), which is aimed at enhancing the
country's exports and use trade expansion as an effective instrument of economic growth and
employment generation. The Department of Commerce has announced increased support for
export of various products and included some additional items under the Merchandise Exports
from India Scheme (MEIS) in order to help exporters to overcome the challenges faced by them.
The Central Board of Excise and Customs (CBEC) has developed an 'integrated declaration'
process leading to the creation of a single window which will provide the importers and
exporters a single point interface for customs clearance of import and export goods. As part of
the FTP strategy of market expansion, India has signed a Comprehensive Economic Partnership
Agreement with South Korea which will provide enhanced market access to Indian exports.
These trade agreements are in line with India‘s Look East Policy. To upgrade export sector
infrastructure, ‗Towns of Export Excellence‘ and units located therein will be granted additional
focused support and incentives. RBI has simplified the rules for credit to exporters, through
which they can now get long-term advance from banks for up to 10 years to service their
contracts. This measure will help exporters get into long-term contracts while aiding the overall
export performance. The Government of India is expected to announce an interest subsidy
scheme for exporters in order to boost exports and explore new markets.
Road Ahead
India is presently known as one of the most important players in the global economic landscape.
Its trade policies, government reforms and inherent economic strengths have attributed to its
standing as one of the most sought after destinations for foreign investments in the world. Also,
technological and infrastructural developments being carried out throughout the country augur
well for the trade and economic sector in the years to come. Boosted by the forthcoming FTP,
India's exports are expected reach US$ 750 billion by 2018-2019 according to Federation of
India Export Organisation (FIEO). Also, with the Government of India striking important deals
with the governments of Japan, Australia and China, the external sector is increasing its
contribution to the economic development of the country and growth in the global markets.
Moreover, by implementing the FTP 2014-19, by 2020, India's share in world trade is expected
to double from the present level of three per cent.

Exchange Rate Used: INR 1 = US$ 0.0154 as on March 28, 2018
The issue of Capital Account Convertibility

Currency convertibility refers to the freedom to convert the domestic currency into other
internationally accepted currencies and vice versa. Current account convertibility means freedom
to convert domestic currency into foreign currency and vice versa to execute trade in goods and
invisibles. On the other hand, capital account convertibility implies freedom of currency
conversion related to capital inflows and outflows. Compared to current account convertibility,
capital account convertibility is a complex issue because of the peculiar feature of capital
account transactions. An important one is the high frequency and volume of international capital
movements across borders which may produce many macroeconomic effects in host countries
like India.
Meaning of Capital Account Convertibility (CAC)

Capital Account Convertibility is not just the currency convertibility freedom, but more than
that, it involves the freedom to invest in financial assets of other countries. The Committee on
Capital Account Convertibility (1997, Chairman Dr S S Tarapore) in its report has given a
working definition for the CAC which is as following. ―CAC refers to the freedom to convert
local financial assets into foreign financial assets and vice versa at market determined rates of
exchange. It is associated with changes of ownership in foreign/domestic financial assets and
liabilities and embodies the creation and liquidation of claims on, or by, the rest of the world.‖
Capital account convertibility is thus the freedom of foreign investors to purchase Indian
financial assets (shares, bonds etc.) and that of the domestic citizens to purchase foreign financial
assets. It provides rights for firms and residents to freely buy into overseas assets such as equity,
bonds, property and acquire ownership of overseas firms besides free repatriation of proceeds by
foreign investors.
Critical Factors in Adopting Capital Account Convertibility (CAC)

There are number of issues which are of concern for adopting CAC in India. Some of which are
as follows:
Short-Term External Borrowings
The impact of allowing unlimited access to short-term external commercial borrowing for
meeting working capital and other domestic requirements. In respect of short-term external
commercial borrowings, there is already a strong international consensus that emerging markets
should keep such borrowings relatively small in relation to their total external debt or reserves.
Many of the financial crises in the 1990s occurred because the short-term debt was excessive.
When times were good, such debt was easily accessible. The position, however, changed
dramatically in times of external pressure. All creditors who could redeem the debt did so within
a very short period, causing extreme domestic financial vulnerability. The occurrence of such a
possibility has to be avoided, and the Indian Reserve would do well to continue with its policy of
keeping access to short-term debt limited as a conscious policy at all times whether good or bad.
Free Convertibility of Domestic Assets

The Indian Monetary System provided unrestricted freedom to domestic residents to convert
their domestic bank deposits and idle assets (such as, real estate), in response to market
developments or exchange rate expectations. The daily movement in exchange rates is
determined by "flows" of funds, that is, by demand and supply of spot or forward transactions in
the market. If supposedly, the exchange rate is depreciating disproportionately and is expected to
continue to do so in the near future, the domestic residents would be likely to convert a part or
whole of their stock of domestic assets from domestic currency to foreign currency. This was
thought to be financially desirable as the domestic value of their converted assets was expected
to increase because of anticipated depreciation. It is furthermore thought that if a large number of
residents so decide simultaneously within a short period of time, as they may, this expectation
would become self-fulfilling. A severe external crisis is then unavoidable.
External Events
External events such as the Kargil war or Pokhran Test Although at present our reserves are high
and exchange rate movements are, by and large, orderly. However, there can be events like
Kargil war or Pokhran Test, which creates external uncertainty. Domestic stock of bank deposits

in rupees in India is presently close to US $ 290 billion, nearly three and a half times our total
reserves. At the time of Kargil or Pokhran or the oil crises, the multiple of domestic deposits
over reserves was in fact several times higher than now. One can imagine what would have had
happened to our external situation, if within a very short period, domestic residents decided to
rush to their neighbourhood banks and convert a significant part of these deposits into sterling,
euro or dollar. No emerging market exchange rate system can cope with this kind of
contingency. This may be an unlikely possibility today, but it must be factored in while deciding
on a long term policy of free convertibility of "stock" of domestic assets. Incidentally, this kind
of eventuality is less likely to occur in respect of industrial countries with international
currencies such as Euro or Dollar, which are held by banks, corporates, and other entities as part
of their long-term global asset portfolio (as distinguished from emerging market currencies in
which banks and other intermediaries normally take a daily long or short position for purposes of
currency trade).
Impact of Capital Account Convertibility

The first impact of CAC adopted by India is the acceptance of Indian Rupee currency all over the
world. In case of two convertible currencies, Forward Exchange Rates reflect interest rate
differentials between these two currencies. Thus, we can say that the Forward Exchange Rate for
the higher interest rate currency would depreciate so as to neutralize the interest rate difference.
However, sometimes there can be opportunities when forward rates do not fully neutralize
interest rate differentials. In such situations, arbitrageurs get into the act and forward exchange
rates quickly adjust to eliminate the possibility of risk-less profits. Capital account convertibility
is likely to bring depth and large volumes in long-term Indian Rupee (INR) currency swap
markets. Thus, for a better market determination of INR exchange rates, the INR should be
convertible. If capital account is made fully convertible it will imply the following:
Market forces will regulate all current and capital account transactions and there will be no
restriction on the inflow or the outflow of capital either by non-resident Indians or by foreigners.
There will be no restriction on foreign exchange transactions and the RBI and the government
will not intervene even where the cost or the quantity of the transaction is concerned.

Purely market forces will determine the exchange rate of rupee in relation to any foreign
currency. RBI can intervene in relation to foreign currency only by buying and selling of the
rupee in the market. Indian companies will be free to go aboard and raise money. They will also
be free to invest in GDR's and maintain offshore funds. Similarly foreign companies will be free
to invest in India without any intervention of the RBI or the government Indian's will be free to
maintain foreign bank accounts and deposit withdraw and maintain foreign currency in any bank
without any restriction. There will be no restriction on the repatriation of capital by foreigners.
Dangers from Capital Account Convertibility in India

At present very few countries permit absolute free market in foreign exchange. Among
developing countries only a handful at present has, what may be called, full convertibility in both
current and capital accounts. Even many industrial countries still do not allow free flows of
capital account transactions. Some of the Latin American countries notably Uruguay, Argentina
and Chile which had prematurely liberalised capital account in the early eighties have
subsequently imposed a very tight control on capital mobility in the subsequent periods. It has
been estimated that eventual capital flights out of these countries have been much more that
initial capital inflows after capital account liberalisation. Some countries have however, notably,
The U.K. and New Zealand, implemented capital account convertibility successfully. An
examination of case study of successful and unsuccessful capital account liberalisation suggest
that capital account liberalisation be best introduced as one of the last steps of economic reforms.
Whenever it was introduced prematurely it had been disastrous. In general it has been observed
that capital account liberalisation and full convertibility of exchange rate succeeds when it
follows (and definitely not precedes) Fiscal reform, price stability, domestic financial reform,
balance of payments stability and acceleration in growth of domestic output, particularly
industrial output. In India very few of these objectives are fulfilled by now. Fiscal deficit of the
Centre after falling from 8.3% of GDP in 1990-91 to 6.0% of GDP in 1991-92, has remained
around that level since then. What is worst is that while real public investment has fallen sharply,
unwarranted subsidies and bureaucratic expenditure have remained virtually at their pre-reform
levels. In fact in some states, subsides, instead of falling have actually increased after the reform.
Inflation continued at 10% per annum for many years after the reform in spite of many
favourable conditions, including good monsoon and low oil price. It has now come down to

around 6% after a very tight squeeze on money and credit since 1995-96. But the credit squeeze
increased both nominal and real interest rates, and currently the interest rates in India are well
above the international levels. The credit squeeze also hampered the growth of industry and
overall growth. Balance of payments situation is far from satisfactory. The improvement in
foreign exchange reserve is more due to special factors like NRI remittances and deposits and
portfolio capital inflow. There is no notable improvement in either trade balance or balance of
payments. There is a dangerous illusion about capital account liberalisation. It is generally
assumed that it can encourage only inflow of capital, ignoring the possibility that once
deregulation is introduced it may also lead to outflow of capital. Experiences suggest that
initially inflow is more than outflow because foreigners take advantage of initial low prices of
shares and properties. Besides domestic residents may also bring back illegal capital held abroad.
But if the real sector of the economy does not improve, especially lags behind more dynamic
economy elsewhere in the world, then capital later goes out. The outflow can be more than
inflow because not only foreigners can take back capital but even domestic residents can take
advantage of the deregulated environment and invest abroad. It would therefore be prudent to
wait for the real improvement of the economy, particular in current account balance, industrial
growth rate, fiscal deficit and financial reform, before entering into an adventurous path of
capital account liberalisation and full convertibility of rupee. Thus India will have to gradually
move towards capital account convertibility, step by step, one reform after the other and then
finally introduce full convertibility of rupee as the last step of economic reforms when all of the
above listed objectives are fulfilled and as Dr. Y.V.Reddy, Deputy Governor RBI, put it as," In
India, it is recognised that the pace of liberalisation of the capital account would depend on both
domestic factors, especially progress in the financial sector reform and the evolving international
financial architecture."
Pros (for) of Capital Account Convertibility for India

It allows domestic residents to invest abroad and have a globally diversified investment
portfolio; this reduces risk and stabilizes the economy. A globally diversified equity portfolio has
roughly half the risk of an Indian equity portfolio. So, even when conditions are bad in India,
globally diversified households will be buoyed by offshore assets; will be able to spend more,
thus propping up the Indian economy. Our NRI Diaspora will benefit tremendously if and when

Capital Account Convertibility becomes a reality. The reason is on account of current restrictions
imposed on movement of their funds. As the remittances made by NRI's are subject to numerous
restrictions which will be eased considerably once Capital Account Convertibility is
incorporated. It also opens the gate for international savings to be invested in India. It is good for
India if foreigners invest in Indian assets - this makes more capital available for India's
development. That is, it reduces the cost of capital. When steel imports are made easier, steel
becomes cheaper in India. Similarly, when inflows of capital into India are made easier, capital
becomes cheaper in India. Controls on the capital account are rather easy to evade through
unscrupulous means. Huge amounts of capital are moving across the border anyway. It is better
for India if these transactions happen in white money. Convertibility would reduce the size of the
black economy, and improve law and order, tax compliance and corporate governance. Most
importantly convertibility induces competition against Indian finance. Currently, finance is a
monopoly in mobilizing the savings of Indian households for the investment plans of Indian
firms. No matter how inefficient Indian finance is, households and firms do not have an
alternative, thanks to capital controls. Exactly as we saw with trade liberalization, which
consequently led to lower prices and superior quality of goods produced in India, capital account
liberalization will improve the quality and drop the price of financial intermediation in India.
This will have repercussions for GDP growth, since finance is the 'brain' of the economy.
Cons (against) of Capital Account Convertibility for India

During the good years of the economy, it might experience huge inflows of foreign capital, but
during the bad times there will be an enormous outflow of capital under "herd behavior" (refers
to a phenomenon where investors acts as "herds", i.e. if one moves out, others follow
immediately). For example, the South East Asian countries received US$ 94 billion in 1996 and
another US$ 70 billion in the first half of 1997. However, under the threat of the crisis, US$ 102
billion flowed out from the region in the second half of 1997, thereby accentuating the crisis.
This has serious impact on the economy as a whole, and can even lead to an economic crisis as in
South-East Asia. There arises the possibility of misallocation of capital inflows. Such capital
inflows may fund low-quality domestic investments, like investments in the stock markets or real
estates, and desist from investing in building up industries and factories, which leads to more
capacity creation and utilisation, and increased level of employment. This also reduces the

potential of the country to increase exports and thus creates external imbalances. An open capital
account can lead to "the export of domestic savings" (the rich can convert their savings into
dollars or pounds in foreign banks or even assets in foreign countries), which for capital scarce
developing countries would curb domestic investment. Moreover, under the threat of a crisis, the
domestic savings too might leave the country along with the foreign 'investments', thereby
rendering the government helpless to counter the threat. Entry of foreign banks can create an
unequal playing field, whereby foreign banks "cherry-pick" the most creditworthy borrowers and
depositors. This aggravates the problem of the farmers and the small-scale industrialists, who are
not considered to be credit-worthy by these banks. In order to remain competitive, the domestic
banks too refuse to lend to these sectors, or demand to raise interest rates to more "competitive"
levels from the 'subsidised' rates usually followed. International finance capital today is "highly
volatile", i.e. it shifts from country to country in search of higher speculative returns. In this
process, it has led to economic crisis in numerous developing countries. Such finance capital is
referred to as "hot money" in today's context. Full capital account convertibility exposes an
economy to extreme volatility on account of "hot money" flows. It does seem that the Indian
economy has the competence of bearing the strains of free capital mobility given its fantastic
growth rate and investor confidence. Most of the pre-conditions stated by the Tarapore
Committee have been well complied to through robust year on year performance in the last five
years especially. The forex reserves provide enough buffer to bear the immediate flight of capital
which although seems unlikely given the macroeconomic variables of the economy alongside the
confidence that international investors have leveraged on India. However it must not be forgotten
that Capital Account Convertibility is a big step and integrates the economy with the global
economy completely thereby subjecting it to international fluctuations and business cycles. Thus
due caution must be incorporated while taking this decision in order to avoid any situation that
was faced by Argentina in the early 80's or by the Asian economies in 1997-98.
Each day we get fascinating news about currency which fuel our curiosity, such as Rupee gains
12 paise against US dollar, Dollar Spot/Forward Rates plummet, Rupee down, Euro holds
steady, Pound strengthens etc. Ever wondered what these and other jargons mean? We shall try
to understand a few fundamentals related to currency transactions in this unit.

We earlier examined the demand for and supply of domestic currency. It is not domestic
currency alone that we need. Households, businesses and governments in India, for example, buy
different types of goods and services produced in other countries. Similarly, residents of the rest
of the world buy goods and services from residents in India. Foreign investors, businesses, and
governments invest in our country, just as our nationals invest in other countries. In the same
way, lending, and borrowing also take place internationally. These and similar other transactions
give rise to an international dimension of money, which involves exchange of one currency for
another. Obviously, this entails market transactions involving determination of price of one
currency in terms of another.
THE EXCHANGE RATE
As all of us know, the term ‗Foreign Exchange‘ refers to money denominated in a currency other
than the domestic currency. Similar to any other commodity, foreign exchange has a price. The
exchange rate, also known as a foreign exchange (FX) rate, is the price of one currency
expressed in terms of units of another currency and represents the number of units of one
currency that exchanges for a unit of another. In other words, exchange rate is the rate at which
the currency of one country exchanges for the currency of another country. It is the minimum
number of units of one country‘s currency required to purchase one unit of the other countries
currency. It is important to note that the value of a currency is relative as it is always given in
terms of another currency.
There are two ways to express nominal exchange rate between two currencies (e.g. the US $ and
Indian Rupee) namely direct quote and indirect quote. The direct form of quotation is also called

European Currency Quotation whereas indirect form is known as American Currency Quotation.
A direct quote is the number of units of a local currency exchangeable for one unit of a foreign
currency. The price of 1 dollar may be quoted in terms of how much rupees it takes to buy one
dollar. For example, Rs. 66/US$ means that an amount of Rs 66 is needed to buy one US dollar
or Rs. 66 will be received while selling one US dollar. An indirect quote is the number of units
of a foreign currency exchangeable for one unit of local currency; for example: $ 0.0151 per
rupee. A quotation in direct form can easily be converted into a quotation in indirect form and
vice-versa. This is done by taking the reciprocal of the given rate.
An exchange rate has two currency components; a ‗base currency‘ and a ‗counter currency‘. In a
direct quotation, the foreign currency is the base currency and the domestic currency is the
counter currency. In an indirect quotation, the domestic currency is the base currency and the
foreign currency is the counter currency. As the US dollar is the dominant currency in global
foreign exchange markets, the general convention is to apply direct quotes that have the US
dollar as the base currency and other currencies as the counter currency.
There may be two pairs of currencies with one currency being common between the two pairs.
For instance, exchange rates may be given between a pair, X and Y and another pair, X and Z.
The rate between Y and Z is derived from the given rates of the two pairs (X and Y, and, X and
Z) and is called ‗cross rate‘. When there is no difference between the buying and the selling rate,
the rate is said to be ‗unique‘ or ‗unified‘. But, in practice, it is rarely so. . There are generally
two rates – selling rate and buying rate – for any currency when one goes to exchange it in the
market. Selling rate is generally higher than the buying rate for a currency. This is the
commission of the money exchanger (dealer) to run its operations.
THE EXCHANGE RATE REGIMES
An exchange rate regime is the system by which a country manages its currency in respect to
foreign currencies. It refers to the method by which the value of the domestic currency in terms
of foreign currencies is determined. There are two major types of exchange rate regimes at the
extreme ends; namely:

(i) floating exchange rate regime (also called a flexible exchange rate), and
(ii) fixed exchange rate regime
Under floating exchange rate regime, the equilibrium value of the exchange rate of a country‘s
currency is market-determined i.e the demand for and supply of currency relative to other
currencies determine the exchange rate. There is no predetermined target rate and the exchange
rates are likely to change at every moment in time depending on the changing demand for and
supply of currency in the market. There is no interference on the part of the government or the
central bank of the country in the determination of exchange rate. Any intervention by the central
banks in the foreign exchange market (through purchases or sales of foreign currency in
exchange for local currency) is intended for only moderating the rate of change and preventing
undue fluctuations in the exchange rate, rather than for establishing a particular level for it.
Nevertheless, in a few countries (for example, New Zealand, Sweden, the United States), the
central banks almost never interfere to administer the exchange rates. Nearly all advanced
economies follow floating exchange rate regimes. Some large emerging market economies also
follow the system.
A fixed exchange rate, also referred to as pegged exchanged rate, is an exchange rate regime
under which a country‘s Central Bank and/ or government announces or decrees what its
currency will be worth in terms of either another country‘s currency or a basket of currencies or
another measure of value, such as gold. For example: a certain amount of rupees per dollar.
(When a government intervenes in the foreign exchange market so that the exchange rate of its
currency is different from what the market would have produced, it is said to have established a
―peg‖ for its currency). In order to sustain a fixed exchange rate, it is not enough that a country
pronounces a fixed parity: it must also make concentrated efforts to defend that parity by being
willing to buy (or sell) foreign reserves whenever the market demand for foreign currency is
lesser (or greater) than the supply of foreign currency. In other words, in order to maintain the
exchange rate at the predetermined level, the central bank intervenes in the foreign exchange
market.

We are often misled to think that it is common for countries to adopt the flexible exchange rate
system. In the real world, there is a spectrum of ‗intermediate exchange rate regimes‘ which are
either inflexible or have varying degrees of flexibility that lie in between these two extremes
(fixed and flexible). For example, a central bank can implement soft peg and hard peg policies. A
soft peg refers to an exchange rate policy under which the exchange rate is generally determined
by the market, but in case the exchange rate tend to be move speedily in one direction, the central
bank will intervene in the market. With a hard peg exchange rate policy, the central bank sets a
fixed and unchanging value for the exchange rate. Both soft peg and hard peg policy require that
the central bank intervene in the foreign exchange market. The tables 4.4.1 and 4.4.2 show
respectively, the IMF classifications and definitions of prevalent exchange rate systems and the
latest available data (as on April 30, 2016) on the distribution of the 189 IMF members based on
their exchange rate regimes.
Table No: 4.4.1

Exchange Rate Regimes Description
Exchange arrangements with no Currency of another country circulates as
separate legal tender sole legal tender or member belongs to
Dollarization a monetary or currency union in which
same legal tender is shared by members
of the union.
Currency Board Arrangements Monetary regime based on implicit
Hong Kong Dollar national commitment to exchange
domestic currency for a specified foreign
currency at a fixed exchange rate
Other conventional fixed peg Country pegs its currency (formal or de
arrangement facto) at a fixed rate to a major currency
Chinese Yuan or a basket of currencies where exchange
rate fluctuates within a narrow margin or
at most ± 1% around central rate
Pegged exchange rates within horizontal Value of the currency is maintained
Bands within margins of fluctuation around a

formal or de facto fixed peg that are
wider than ± 1% around central rate.
Crawling Peg Currency is adjusted periodically in small
amounts at a fixed, preannounced rate in
response to changes in certain
quantitative indicators
Crawling Bands Currency is maintained within certain
fluctuation margins say ( ±1-2 %)
around a central rate that is adjusted
periodically
Managed floating within no Monetary authority influences the
preannounced path for exchange rate: movements of the exchange rate
Indian Rupee through active intervention in foreign
exchange markets without specifying a
pre-announced path for the exchange
rate
Independent floating Exchange rate is market determined,
US Dollar, Japanese Yen, New Zealand with any foreign exchange intervention
Dollar aimed at moderating the rate of change
and preventing undue fluctuations in the
exchange rate, rather than at
establishing a level for it
Table No: 4.4.2

Distribution of IMF Members Based on Exchange Regime
Exchange Rate Arrangement % of IMF Members
Hard peg 13.0

No separate legal tender 7.3
Currency board 5.7
Soft peg 39.6
Conventional peg 22.9
Stabilized arrangement 9.4
Crawling peg 1.6
Crawl-like arrangement 5.2
Pegged exchange rate within horizontal bands 0.5
Floating 37.0
Floating 20.8
Free floating 16.1
Other managed Arrangements 10.4
Source: Annual Report on Exchange Arrangements and Exchange Restrictions, IMF
In an open economy, the main advantages of a fixed rate regime are:

I. A fixed exchange rate avoids currency fluctuations and eliminates exchange rate risks
and transaction costs that can impede international flow of trade and investments. A fixed
exchange rate can thus greatly enhance international trade and investment.
II. A fixed exchange rate system imposes discipline on a country‘s monetary authority and
therefore is more likely to generate lower levels of inflation.
III. The government can encourage greater trade and investment as stability encourages
investment.
IV. Exchange rate peg can also enhance the credibility of the country‘s monetary-policy
V. However, in the fixed or managed floating (where the market forces are allowed to
determine the exchange rate within a band) exchange rate regimes, the central bank is required to
stand ready to intervene in the foreign exchange market and, also to maintain an adequate
amount of foreign exchange reserves for this purpose.
Basically, the free floating or flexible exchange rate regime is argued to be efficient and highly
transparent as the exchange rate is free to fluctuate in response to the supply of and demand for
foreign exchange in the market and clears the imbalances in the foreign exchange market without
any control of the central bank or the monetary authority. A floating exchange rate has many
advantages:
(i) A floating exchange rate has the great advantage of allowing a Central bank and /or
government to pursue its own independent monetary policy
(ii) Floating exchange rate regime allows exchange rate to be used as a policy tool: for
example, policy-makers can adjust the nominal exchange rate to influence the competitiveness of
the tradeable goods sector

(iii) As there is no obligation or necessity to intervene in the currency markets, the central
bank is not required to maintain a huge foreign exchange reserves.
However, the greatest disadvantage of a flexible exchange rate regime is that volatile exchange
rates generate a lot of uncertainties in relation to international transactions, and add a risk
premium to the costs of goods and assets traded across borders. In short, a fixed rate brings in
more currency and monetary stability and credibility; but it lacks flexibility. On the contrary, a
floating rate has greater policy flexibility; but less stability.
NOMINAL VERSUS REAL EXCHANGE RATES
We have been discussing so far about nominal exchange rate which simply states how much of
one currency (i.e. money) can be traded for a unit of another currency when prices are constant.
When prices of goods and services change in either or both countries, it would be difficult to
know the change in relative prices of foreign goods and services. Therefore, Real Exchange Rate
(RER) which incorporates changes in prices is a better measure. The ‗real exchange rate'
describes ‗how many‘ of a good or service in one country can be traded for ‗one‘ of that good or
service in a foreign country. It is calculated as :
Real exchange rate = Nominal exchange rate X Domestic Price Index
Foreign price Index
Another exchange rate concept, the Real Effective Exchange Rate (REER) is the nominal
effective exchange rate (a measure of the value of a domestic currency against a weighted
average of variouis foreign currencies) divided by a price deflator or index of costs. An increase
in REER implies that exports become more expensive and imports become cheaper; therefore, an
increase in REER indicates a loss in trade competitiveness.
THE FOREIGN EXCHANGE MARKET

The wide-reaching collection of markets and institutions that handle the exchange of foreign
currencies is known as the foreign exchange market. In this market, the participants use one
currency to purchase another currency. The foreign exchange market operates worldwide and is
by far the largest market in the world in terms of cash value traded. Being an over-the-counter
market, it is not a physical place; rather, it is an electronically linked network of big banks,
dealers and foreign exchange brokers who bring buyers and sellers together. With no central
trading location and no set hours of trading, the foreign exchange market involves enormous
volume of foreign exchange trading worldwide. The participants such as firms, households, and
investors who demand and supply currencies represent themselves through their banks and key
foreign exchange dealers who respond to market signals transmitted instantly across the world.
The foreign exchange markets operate on very narrow spreads between buying and selling
prices. But since the volumes traded are very large, the traders in foreign exchange markets stand
to make huge profits or losses.
The major participants in the exchange market are central banks, commercial banks,
governments, foreign exchange Dealers, multinational corporations that engage in international
trade and investments, nonbank financial institutions such as asset-management firms, insurance
companies, brokers, arbitrageurs and speculators. The central banks participate in the foreign
exchange markets, not to make profit, but essentially to contain the volatility of exchange rate to
avoid sudden and large appreciation or depreciation of domestic currency and to maintain
stability in exchange rate in keeping with the requirements of national economy. If the domestic
currency fluctuates excessively, it causes panic and uncertainty in the business world.
Commercial banks participate in the foreign exchange market either on their own account or for
their clients. When they trade on their own account, banks may operate either as speculators or
arbitrageurs/or both. The bulk of currency transactions occur in the interbank market in which
the banks trade with each other. Foreign exchange brokers participate in the market as
intermediaries between different dealers or banks. Arbitrageurs profit by discovering price
differences between pairs of currencies with different dealers or banks. Speculators, who are
bulls or bears, are deliberate risk-takers who participate in the market to make gains which result
from unanticipated changes in exchange rates. Other participants in the exchange market are

individuals who form only a very insignificant fraction in terms of volume and value of
transactions.
Regardless of physical location, and given that the markets are highly integrated, at any given
moment, all markets tend to have the same exchange rate for a given currency. This phenomenon
occurs because of arbitrage. Arbitrage refers to the practice of making risk-less profits by
intelligently exploiting price differences of an asset at different dealing locations. There is
potential for arbitrage in the forex market if exchange rates are not consistent between
currencies. When price differences occur in different markets, participants purchase foreign
exchange in a low-priced market for resale in a high-priced market and makes profit in this
process. Due to the operation of price mechanism, the price is driven up in the low-priced market
and pushed down in the high -priced market. This activity will continue until the prices in the
two markets are equalized, or until they differ only by the amount of transaction costs involved
in the operation. Since forex markets are efficient, any profit spread on a given currency is
quickly arbitraged away.
In the foreign exchange market, there are two types of transactions:
(i) current transactions which are carried out in the spot market and the exchange involves
immediate delivery, and
(ii) contracts to buy or sell currencies for future delivery which are carried out in forward
and/or futures markets
Exchange rates prevailing for spot trading (for which settlement by and large takes two days) are
called spot exchange rates. The exchange rates quoted in foreign exchange transactions that
specify a future date are called forward exchange rates. The currency forward contracts are
quoted just like spot rate; however, the actual delivery of currencies takes place at the specified
time in future. When a party agrees to sell euro for dollars on a future date at a forward rate
agreed upon, he has ‗sold euros forward‘ and ‗bought dollars forward‘. A forward premium is
said to occur when the forward exchange rate is more than a spot trade rates. On the contrary, if

the forward trade is quoted at a lower rate than the spot trade, then there is a forward discount.
Currency futures, though conceptually similar to currency forward and perform the same
function, they are distinct in their nature and details concerning settlement and delivery.
While a foreign exchange transaction can involve any two currencies, most transactions involve
exchanges of foreign currencies for the U.S. dollars even when it is not the national currency of
either the importer or the exporter. On account of its critical role in the forex markets, the dollar
is often called a ‗vehicle currency‘.
DETERMINATION OF NOMINAL EXCHANGE RATE
As you already know, the key framework for analyzing prices is the operation of supply and
demand in markets. Usually, the supply of and demand for foreign exchange in the domestic
foreign exchange market determine the external value of the domestic currency, or in other
words, a country‘s exchange rate.
Individuals, institutions and governments participate in the foreign exchange market for a
number of reasons. On the demand side, people desire foreign currency to:
• purchase goods and services from another country
• for unilateral transfers such as gifts, awards, grants, donations or endowments
• to make investment income payments abroad
• to purchase financial assets, stocks or bonds abroad
• to open a foreign bank account
• to acquire direct ownership of real capital, and
• for speculation and hedging activities related to risk-taking or risk-avoidance activity

The participants on the supply side operate for similar reasons. Thus, the supply of foreign
currency to the home country results from purchases of home exports, unilateral transfers to
home country, investment income payments, foreign direct investments and portfolio
investments, placement of bank deposits and speculation.
We shall now look into how the foreign exchange markets work. Similar to any standard market,
the exchange market also faces a downward-sloping demand curve and an upward-sloping
supply curve.
Determination of Nominal Exchange Rate

The equilibrium rate of exchange is determined by the interaction of the supply and demand for a
particular foreign currency. In figure, the demand curve (D$) and supply curve (S$ )of dollars
intersect to determine equilibrium exchange rate eeq with Qe as the equilibrium quantity of
dollars exchanged.
CHANGES IN EXCHANGE RATES
Changes in exchange rates portray depreciation or appreciation of one currency. The terms, `
currency appreciation‘ and ‗currency depreciation‘ describe the movements of the exchange rate.
Currency appreciates when its value increases with respect to the value of another currency or a
basket of other currencies. On the contrary, currency depreciates when its value falls with respect
to the value of another currency or a basket of other currencies. We shall try to understand this
with the help of an example.
Now suppose, the Rupee dollar exchange rate in the month of January is $1 = Rs. 65. And, we
find that in the month of April it is $1 = Rs. 70. What does this indicate? In April, you will have
to exchange a greater amount of Indian Rupees (Rs. 70) to get the same 1 US dollar. As such, the
value of the Indian Rupee has gone down or Indian Rupee has depreciated in its value. Rupee
depreciation here means that the rupee has become less valuable with respect to the U.S. dollar.
Simultaneously, if you look at the value of dollar in terms of Rupees, you find that the value of
the US dollar has increased in terms of the Indian Rupee. One dollar will now fetch ` 70 instead
of Rs. 65 earlier. This is called appreciation of the US dollar. You might have observed that
when one currency depreciates against another, the second currency must simultaneously
appreciate against the first.

To put it more clearly:
• Home-currency depreciation (which is the same as foreign-currency appre-ciation) takes

place when there is an increase in the home currency price of the foreign currency (or,
alternatively, a decrease in the foreign currency price of the home currency). The home currency
thus becomes relatively less valuable.
• Home-currency appreciation or foreign-currency depreciation takes place when there is a

decrease in the home currency price of foreign currency (or alternatively, an increase in the
foreign currency price of home currency). The home currency thus becomes relatively more
valuable.
Under a floating rate system, if for any reason, the demand curve for foreign currency shifts to
the right representing increased demand for foreign currency, and supply curve remains
unchanged, then the exchange value of foreign currency rises and the domestic currency

depreciates in value. This is illustrated in figure.
The market reaches equilibrium at point E with equilibrium exchange rate e eq. An increase in
domestic demand for the foreign currency, with supply of dollars remaining constant, is
represented by a rightward shift of the demand curve to D1$.
The equilibrium exchange rate rises to e1. It means that more units of domestic currency (here
Indian Rupees) are required to buy a unit of foreign exchange (dollar) and that the domestic
currency (the Rupee) has depreciated.
We shall now examine what happens when there is an increase in the supply of dollars in the
Indian market. This is illustrated in figure

Home-Currency Appreciation under Floating Exchange Rates
An increase in the supply of foreign exchange shifts the supply curve to the right to S1 $ and as a
consequence, the exchange rate declines to e1. It means, that lesser units of domestic currency
(here Indian Rupees) are required to buy a unit of foreign exchange (dollar), and that the
domestic currency (the Rupee) has appreciated.
As we are aware, in an open economy, firms and households use exchange rates to translate
foreign prices into domestic currency terms. Exchange rates also permit us to compare the prices
of goods and services produced in different countries. Furthermore, import or export prices could
be expressed in terms of the same currency in the trading contract. This is the reason why
exchange rate movements can affect intentional trade flows.

DEVALUATION (REVALUATION) VS DEPRECIATION (APPRECIATION)
Devaluation is a deliberate downward adjustment in the value of a country's currency relative to

another currency, group of currencies or standard. It is a monetary policy tool used by countries
that have a fixed exchange rate or nearly fixed exchange rate regime and involves a discrete
official reduction in the otherwise fixed par value of a currency. The monetary authority formally
sets a new fixed rate with respect to a foreign reference currency or currency basket. In contrast,
depreciation is a decrease in a currency's value (relative to other major currency benchmarks)
due to market forces under a floating exchange rate and not due to any government or central
bank policy actions.
Revaluation is the opposite of devaluation and the term refers to a discrete raising of the
otherwise fixed par value of a nation‘s currency. Appreciation, on the other hand, is a increase in
a currency's value (relative to other major currencies) due to market forces under a floating
exchange rate and not due to any government or central bank policy interventions.
IMPACTS OF EXCHANGE RATE FLUCTUATIONS ON DOMESTIC ECONOMY
The fact that among the macroeconomic variables, exchange rates are perhaps the most closely
monitored, analyzed and manipulated economic measure highlights the overwhelming
importance of exchange rates in an economy. The unpredictability of the markets caused by
exchange rate changes can profoundly influence the economy of countries. As a matter of fact, it
is most likely that exchange rate fluctuations may determine a country‘s economic performance.
Knowledge about the possible effects of exchange rate fluctuations enables us to have an
understanding of the appropriateness of exchange rate policy, especially in developing countries.

In the discussion that follows, we shall examine the impact of exchange rate fluctuations on the
real economy.
The developments in the foreign exchange markets affect the domestic economy both directly
and indirectly. The direct impact of fluctuations in rates is initially felt by economic agents who
are directly involved in international trade or international finance. In judging the impacts of
exchange rate fluctuations, it becomes, therefore, necessary to evaluate their effects on trade,
investments, consumption output, economic growth and inflation.
(i) Exchange rates have a very significant role in determining the nature and extent of a
country's trade. Changes in import and export prices will lead to changes in import and export
volumes, causing changes in import spending and export revenue.
(ii) Fluctuations in the exchange rate affect the economy by changing the relative prices of
domestically-produced and foreign-produced goods and services. All else equal (or other things
remaining the same), an appreciation of a country‘s currency raises the relative price of its
exports and lowers the relative price of its imports. Conversely, a depreciation lowers the relative
price of a country‘s exports and raises the relative price of its imports. When a country‘s
currency depreciates, foreigners find that its exports are cheaper and domestic residents find that
imports from abroad are more expensive. An appreciation has opposite effects i.e foreigners pay
more for the country‘s products and domestic consumers pay less for foreign products. For
example; assume that there is devaluation or depreciation of Indian Rupee from $1=Rs 65/ to
$1=Rs 70/.A foreigner who spends ten dollars on buying Indian goods will, post devaluation, get
goods worth Rs.700/ instead of Rs 650/ prior to depreciation. An importer has to pay for his
purchases in foreign currency, and, therefore, a resident of India, who wants to import goods
worth $1 will have to pay Rs 70/ instead of Rs 65/ prior to depreciation. Importers will be
affected most as they will have to pay more rupees on importing products. On the contrary,
exporters will be benefitted as goods exported abroad will fetch dollars which can now be
converted to more rupees.

(iii) Exchange rate changes affect economic activity in the domestic economy. A depreciation
of domestic currency primarily increases the price of foreign goods relative to goods produced in
the home country and diverts spending from foreign goods to domestic goods. Increased
demand, both for domestic import-competing goods and for exports encourages economic
activity and creates output expansion. Overall, the outcome of exchange rate depreciation is an
expansionary impact on the economy at an aggregate level. The positive effect of currency
depreciation, however, largely depends on whether the switching of demand has taken place in
the right direction and in the right amount, as well as on the capacity of the home economy to
meet the additional demand by supplying more goods to meet the increased domestic demand.
(iv) By lowering export prices, currency depreciation helps increase the international
competitiveness of domestic industries, increases the volume of exports and promotes trade
balance. However, a point to be noted is that the price changes in exports and imports may
counterbalance or offset each other only if trade is in balance and terms of trade are not changed.
In case the country‘s imports exceed exports, the net result is a reduction in real income within
the country.
(v) We have seen above that by changing the relative prices, depreciation may increase
windfall profits in export and import-competing industries. However, depreciation may also
cause contractionary effects. We shall see how it may happen. In an under developed or semi
industrialized country, where - inputs (such as oil) and components for manufacturing are mostly
imported and cannot be domestically produced, increased import prices will increase firms‘ cost
of production , push domestic prices up and decrease real output.
(vi) For an economy where exports are significantly high, a depreciated currency would mean
a lot of gain. In addition, if exports originate from labour-intensive industries, increased export
prices will have positive effect employment income and potentially on wages.
(vii) Depreciation is also likely to add to consumer price inflation in the short run, directly
through its effect on prices of imported consumer goods and also due to increased demand for
domestic goods. The impact will be greater if the composition of domestic consumption baskets

consists more of imported goods. Indirectly, cost push inflation may result through possible
escalation in the cost of imported inputs. In such an inflationary situation, the central bank of the
country will have no incentive to cut policy rates as this is likely to increase the burden of all
types of borrowers including businesses.
(viii) When a country‘s currency depreciates, production for exports and of import substitutes
become more profitable. Therefore, factors of production will be induced to move into the
tradable goods sectors and out of the non tradable goods sectors. The reverse will be true when
the currency appreciates. These types of resource movements involve economic wastes.
(ix) A depreciation or devaluation is also likely to affect a country‘s terms of trade. (Terms of
trade is the ratio of the price of a country‘s export commodity to the price of its import
commodity) Since the prices of both exports and imports rise in terms of the domestic currency
as a result of depreciation or devaluation, the terms of trade of the nation can rise , fall or remain
unchanged, depending on whether price of exports rises by more than , less than or same
percentages as price of imports.
(x) The fiscal health of a country whose currency depreciates is likely to be affected with
rising export earnings and import payments and consequent impact on current account balance.
A widening current account deficit is a danger signal as far as growth prospects of the overall
economy is concerned. If export earnings rise faster than the imports spending then current
account will improve otherwise not.
(xi) Companies that have borrowed in foreign exchange through external commercial
borrowings (ECBs) but have been careless and did not sufficiently hedge these loans against
foreign exchange risks would also be negatively impacted as they would require more domestic
currency to repay their loans. A depreciated domestic currency would also increase their debt
burden and lower their profits and impact their balance sheets adversely. These would signal
investors who will be discouraged from investing in such companies.

(xii) Countries with foreign currency denominated government debts, currency depreciation
will increase the interest burden and cause strain to the exchequer for repaying and servicing
foreign debt. Fortunately, India‘s has small proportion of public debt in foreign currency.
(xiii) Exchange rate fluctuations make financial forecasting more difficult for firms and larger
amounts will have to be earmarked for insuring against exchange rate risks through hedging.
(xiv) With growth of investments across international boundaries, exchange rates have
assumed special significance. Investors who have purchased a foreign asset, or the corporation
which floats a foreign debt, will find themselves facing foreign exchange risk. Exchange rate
movements have become the single most important factor affecting the value of investments on
an international level. They are critical to business volumes, profit forecasts, investment plans
and investment outcomes. Depreciating currency hits investor sentiments and has radical impact
on patterns of international capital flows.
(xv) Foreign investors are likely to be indecisive or highly cautious before investing in a
country which has high exchange rate volatility. Foreign capital inflows are characteristically
vulnerable when local currency weakens. Therefore foreign portfolio investment flows into debt
and equity as well as foreign direct investment flows are likely to shrink. This shoots up capital
account deficits affecting the country‘s fiscal health. If investor sentiments are such that they
anticipate further depreciation, there may be large scale withdrawal of portfolio investments and
huge redemptions through global exchange traded funds leading to further depreciation of
domestic currency. This may result in a highly volatile domestic equity market affecting the
confidence of domestic investors. Reduced foreign investments also widen the gap between
investments required for growth and actual investments. Over a period of time, unemployment is
likely to mount in the economy.
With increasing dependence on imports, Indian economy has always felt the brunt of higher
international prices of fuel impacting domestic transportation and overall cost of production
which often triggered inflation, increase in oil and fertilizer subsidy bills, costly foreign travel,

escalated foreign debt service payments and higher outstanding external commercial borrowings
(or ECB) and government‘s foreign debt.
The other impacts of currency depreciation are:
(i) Windfall gains for export oriented sectors (such as IT sector, textile, pharmaceuticals,
gems and jewelry in the case of India) because depreciating currency fetches more domestic
currency per unit of foreign currency.
(ii) Remittances to homeland by non residents and businesses abroad fetches more in terms
of domestic currency
(iii) Depreciation would enhance government revenues from import related taxes, especially
if the country imports more of essential goods
(iv) Depreciation would result in higher amount of local currency for a given amount of
foreign currency borrowings of government.
(v) Depreciation also can have a positive impact on country‘s trade deficit as it makes
imports more expensive for domestic consumers and exports cheaper for foreigners.
(vi) Depreciation also can have a positive impact on controlling spiraling gold imports
(mostly wasteful) and thereby improve trade balance.
An appreciation of currency or a strong currency (or possibly an overvalued currency) makes the
domestic currency more valuable and, therefore, can be exchanged for a larger amount of foreign
currency. An appreciation will have the following consequences on real economy:
(i) An appreciation of currency raises the price of exports and, therefore, the quantity of
exports would fall. Since imports become cheaper, we may expect an increase in the quantity of

imports. Combining these two effects together, the domestic aggregate demand falls and,
therefore, economic growth is likely to be negatively impacted.
(ii) The outcome of appreciation also depends on the stage of the business cycle as well. If
appreciation sets in during the recessionary phase, the result would be a further fall in aggregate
demand and higher levels of unemployment. If the economy is facing a boom, an appreciation of
domestic currency would trim down inflationary pressures and soften the rate of growth of the
economy.
(iii) An appreciation may cause reduction in the levels of inflation because imports are
cheaper. Lower price of imported capital goods, components and raw materials lead to decrease
in cost of production which reflects on decrease in prices. Additionally, decrease in aggregate
demand tends to lower demand pull inflation. Living standards of people are likely to improve
due to availability of cheaper consumer goods.
(iv) With increasing export prices, the competitiveness of domestic industry is adversely
affected and, therefore, firms have greater incentives to introduce technological innovations and
capital intensive production to cut costs to remain competitive.
(v) Increasing imports and declining exports are liable to cause larger deficits and worsen the
current account. However, - the impact of appreciation on current account depends upon the
elasticity of demand for exports and imports. Relatively inelastic demand for imports and exports
may lead to an improvement in the current account position. Higher the price elasticity of
demand for exports , greater would be the fall in demand and higher will be the fall in the
aggregate value of exports. This will adversely affect the current account balance.
(vi) Loss of competitiveness will be insignificant if currency appreciation is because of strong

fundamentals of the economy.
From the discussions, we understand that all countries would desire to have steady exchange
rates to eliminate the risks and uncertainties associated with international trade and investments.

However, nations may sometimes go in for tradeoffs with weaker exchange rate to stimulate
exports and aggregate demand, or a stronger exchange rate to fight inflation. Learners may keep
themselves well-informed on contemporary exchange rate developments and their implications
on the economic welfare of countries.
Module 4
International monetary system refers to the system prevailing in world foreign exchange markets
through which international trade and capital movements are financed and exchange rates are
determined. We discuss below the international monetary system since the end of the World War
II.
THE BRETTON WOODS SYSTEM
During the period preceding World War I almost all the major national currencies were on a
system of fixed exchange rates under the international gold standard. This system had to be
abandoned during World War I. There were fluctuating exchange rates from the end of the War
to 1925. Efforts were made to return to the gold standard from 1925. But it collapsed with the
coming of the Great Depression. Many countries resorted to protectionism and competitive
devaluations—with the result that world trade was reduced to almost half. But depression
completely disappeared during World War II. In July 1944, the allied countries met at Bretton
Woods in the USA to avoid the rigidity of the gold standard and the chaos of the 1930s in
international trade and finance and to encourage free trade. The new system was the present
International Monetary Fund (IMF) which worked out an adjustable peg system. Under the
Bretton Woods system exchange rates between countries were set or pegged in terms of gold or
the US dollar at $ 35 per ounce of gold. This related to a fixed exchange rate regime with
changes in the exchange within a band or range from 1 per cent above to 1 per cent below the par
value. But these adjustments were not available to US which had to maintain the gold value of
dollar. If the exchange rate hit either of the bands, the monetary authorities were obliged to buy
or sell dollars against their currencies. Large adjustments could be made where there were
―fundamental disequilibrium‖ (i.e. persistent and large deficits or surpluses) in BOP with the
approval of the IMF and other countries. Member countries were forbidden to impose restrictions
on payments and trade, except for a transitional period. They were allowed to hold foreign
reserves partly in gold and partly in dollars. These reserves were meant to incur temporary
deficits or surpluses by member countries, while keeping their exchange rates stable. In case of a

BOP deficit, there was a reserve outflow by selling dollar and reserve inflow in case of a BOP
surplus. Reserve outflows were a matter of concern under the Bretton Woods system. So the IMF
insisted on expenditure reducing policies and devaluation to correct BOP deficit. Temporary
BOP deficits were also met by borrowing from the Fund for a period of 3 to 5 years. A country
could borrow from the Fund on the basis of the size of its quota with it. The loans made by the
IMF were in convertible currencies. The first 25 per cent of its quota was in gold tranche which
was automatic and the remaining under the credit tranches which carried high interest rates. To
provide long-term loans the World Bank (or IBRD) was set up in 1946 and subsequently its two
affiliates, the International Finance Corporation (IFC) in 1956 and International Development
Association (IDA), in 1960. For the removal of trade restrictions, the General Agreement on
Tariffs and Trade (GATT) came into force from January 1948. To supplement its resources, the
Fund started borrowing from the ten industrialised countries in order to meet the requirements of
the international monetary system under General Agreements to Borrow (GAB) from October
1962. Further, it created special Drawing Rights (SDRs) is January 1970 to supplement
international reserves to meet the liquidity requirements of its members. The Bretton Woods
system worked smoothly from 1950s to mid 1960s. During this period world output increased
and with the reduction of tariffs under the GATT, world trade also rose.
THE BREAKDOWN OF THE BRETTON WOODS SYSTEM The following are the principal
causes and sequences of the breakdown of the Bretton Woods system. 1. Built-in Instability. The
Bretton Woods System had a built-in instability that ultimately led to its breakdown. It was an
adjustable peg system within plus or minus 1 per cent of the par value of $ 35. In case of
fundamental disequilibrium, a country could devalue its currency with the approval of the IMF.
But countries were reluctant to devalue their currencies because they had to export more goods
in order to pay for dearer imports from other countries. This led countries to rely on deflation in
order to cure BOP deficits through expenditure-reducing monetary-fiscal policies. The UK often
restored to deflation such as in 1949, 1957 and 1967. 2. The Triffin Dilemma. Since the dollar
acted as a medium of exchange, a unit of account and a store of value of the IMF system, every
country wanted to increase its reserves of dollar which led to dollar holdings to a greater extent
than needed. Consequently, the US gold stock continued to decline and the US balance of
payments continued to deteriorate. Robert Triffin warned in 1960 that the demand for world
liquidity was growing faster than the supply because the incremental supply of gold was

increasing little. Since the dollar was convertible into gold, the supply of US dollars would be
inadequate in relation to the liquidity needs of countries. This would force the US to abandon its
commitment to convert dollars into gold. This is the Triffin Dilemma which actually led to the
collapse of the Bretton Woods System in August 1971. 3. Lack of International Liquidity. There
was a growing lack of international liquidity due to increasing demand for the dollar in world
monetary markets. With the expansion of world trade, BOP deficits (and surpluses) of countries
increased. This necessitated the supply of gold and of the dollar. But the production of gold in
Africa was increasing very little. This led to larger demand and holdings of the dollar. Countries
also wanted to have more dollar holdings because they earned interest. As the supply of dollars
was inadequate in relation to the liquidity needs of countries, the US printed more dollars to pay
for its deficits which other countries accepted as reserves. 4. Mistakes in US Policies. The BOP
deficits of the US became steadily worse in the 1960s. To overcome them, the policies adopted
by the US government ultimately led to the world crises. Rising US government expenditure in
the Vietnam War, the financing of US space programme and the establishment of the ―Great
Society‖ (social welfare) programme in the 1960s led to large outflow of dollar from the US. But
the US monetary authority (FED) did not devalue the dollar. Rather, it adopted monetary and
fiscal measures to cut its BOP deficit. 5. Destabilising Speculation. Since countries with
―fundamental disequilibrium‖ in BOP were reluctant to devalue their currencies and also took
time to get the approval of the IMF, it provided speculators an opportunity to resort to
speculation in dollars. When devaluations were actually made, there were large doses of
devaluation than originally anticipated. This was due to destabilising speculation which made
controls over capital flows even through monetary-fiscal measures ineffective. This was the
immediate reason for the UK to devalue the pound in 1967. 6. Crisis of Confidence and
Collapse. The immediate cause of the collapse of the Bretton Woods System was the eruption of
a crisis of confidence in the US dollar. The pound had been devalued in November 1967. There
was no control over the world gold market with the appearance of a separate price in the open
market. The immediate cause for the collapse of the Bretton Woods System was the rumour in
March 1971 that the US would devalue the dollar. This led to a huge outflow of capital from the
US. On 15 August 1971, the US suspended the conversion of dollars into gold when some small
European central banks wanted to convert their dollar reserves into gold at the US. It refused to
intervene in the foreign exchange markets to maintain exchange rate stability and imposed a 10%

import surcharge. Thus the main cause of breakdown of the Bretton Woods System was the
problems of liquidity, adjustment and confidence. The increase in liquidity (international
reserves) was in the form of dollars arising from BOP deficits of the US. But as the US was
unable to adjust its deficits and excessive dollars accumulated in foreign countries, there was a
crisis of confidence in the dollar and the Bretton Woods System brokedown. Between 15 August
1971 and the Smithsonian Agreement of 18 December 1971, 48 countries including the United
States, Japan and a large number of European countries abandoned fixed exchange rates. The
‗Group of Ten‘ industrial countries met at the Smithsonian Institution in Washington on 18-19
December, 1971 and agreed to a new system of stable exchange rate with wider bands. As a first
step towards realignment of major currencies, the US, devalued the dollar by 8 per cent, the
Japanese revalued the yen by 17 per cent and the Germans their mark by 14 per cent. The
Smithsonian Agreement widened the margin of fluctuations of the exchange rates to 2.25 per
cent above or below the new parities of central rates. It officially devalued the dollar against gold
from $ 35 to $ 38 per ounce. In 1973, the band was widened to 4.5 per cent. The Smithsonian
Agreement broke down following the devaluation of the US dollar by 10% in February, 1973.
Another development took place in Europe when the EEC countries decided to limit the
fluctuation of their currencies relative to each other to a smaller band. This came to be known as
―the snake in the tunnel‖. Under this arrangement, the EEC currencies were tied together and
could fluctuate within narrow limits in relation to one another but could fluctuate in relation to
other currencies within the limits set by the band proposals.
3. THE PRESENT INTERNATIONAL MONETARY SYSTEM At the beginning of March
1973 India, Canada, Japan, Switzerland, the UK and several smaller countries had floating
exchange rates. However, the ―joint float‖ of the EEC countries continued even after March
1973 and was now called the ―snake in the lake‖, as there was no band within which the EEC
currencies could fluctuate relative to other currencies. In March, 1979 the European
Monetary System (EMS) was formed which created the European Currency Unit (ECU)
which is a ―basket‖ currency of a unit of account consisting of the major European
currencies. The EMS limits the internal exchange rate movement of the member countries to
not more than 2.25 per cent from the ―central rates‖ with the exception of Italy whose lira can
fluctuate up to 6 per cent. In the meantime, the Jamaica Agreement of January 1976 (ratified
in April 1978) formalised the regime of floating exchange rates under the auspices of the

IMF. A number of factors forced the majority of member countries of the IMF to float their
currencies. There were large short-term capital movements and central banks failed to stop
speculation in currencies during the regime of adjustable pegs. The oil crisis in 1973 and the
increase in oil prices in 1974 led to the great recession of 1974-75 in the industrial countries
of the world. As a result ―the dollar went into a rapid decline, which, by late 1978, had such
alarming proportions that the United States government finally decided on a policy of
massive intervention in order to prevent a further fall in the value of the dollar‖. At last, the
system of managed floating exchange rates had come to stay by 1978. By the Second
Amendment of the IMF Charter in 1978, the member countries are not expected to maintain
and establish par values with gold or dollar. The Fund has no control over the exchange rate
adjustment policies of the member countries. But it exercises international ―surveillance‖ of
exchange rate policies of its members. The Second Amendment has reduced the position of
gold in the global monetary system in the following ways by : (a) abolishing the official price
of gold; (b) delinking it with the dollar in exchange arrangements; (c) eliminating the
obligations of the Fund and its members to transfer or receive gold; and (d) selling a part of
Fund‘s gold holdings. The Second Amendment has also made SDRs as the chief reserve
assets of the global monetary system whose value is expressed in currencies and not gold. It
is now a unit of account, a currency peg and medium of transactions. The present
international monetary system of floating exchange rates is not one of free flexible exchange
rates but of ―managed floating‖. It has rarely operated without government intervention.
Periodic intervention by governments has led the system to be called a ―managed‖ or ―dirty‖
floating system. In 1977, when the intervention was very heavy, it was characterised as a
―filthy‖ float. When Governments do not intervene, it is a ―clean‖ float. But the possibilities
of a clean float are very remote. Thus a system of managed floating exchange rates is
evolving where the central banks are trying to control fluctuations of exchange rates around
some ―normal‖ rates even though the Second Amendment of the Fund makes no mention of
normal rates.
―The present international monetary system has also evolved in a number of important ways,
including new allocation of SDRs, increased nations‘ quota in the IMF, renewal of the General
Agreements to Borrow (GAB), the abolishment of the official gold price, and the formation of
the European Monetary System (EMS) and the Euro Currency.‖1 The US is the major country

which has been influencing the global monetary system. It has permitted the dollar to float in
realtion to other currencies with occasional interventions when the dollar has reached extreme
highs or lows. When the dollar was extremely high (appreciating), the G-5 (US, UK, Germany,
Japan and France) agreed to intervene to bring the dollar down by the Plaza Accord in September
1985. Subsequently, the dollar depreciated substantially i.e. by more than 50% relative to the
yen. By early 1987, the dollar had become undervalued and by the Louvre Accord, the G-7
countries (G-5 plus Canada and Italy) agreed to cooperate in keeping their exchange rates around
their current levels at that time. ―The Louvre Accord was successful in stabilising exchange rates
for the rest of the year. Since then there seems to have been a consensus that exchange rates
should be broadly stabilised, but there is little overt cooperation among countries.‖
ITS PROBLEMS The present international monetary system is faced with excessive
fluctuations and large disequilibria in exchange rates. Often countries, both developed and
developing, have been faced with either excessive appreciation or depreciation of their
currencies in relation to the dollar which continues to dominate the world monetary system. Even
the newly created Euro of the EU which was supposed to be a strong currency has been
depreciating considerably since its inception against the dollar. This has adversely affected the
world trade.
SUGGESTIONS TO REFORM THE PRESENT MONETARY SYSTEM
Economists have suggested a number of measures in order to avoid the excessive fluctuations
and large disequilibria in exchange rates for reforming the present world monetary system. 1.
Coordination and Cooperation of Policies. A few economists, and McKinnon in particular,
suggested international co-operation and co-ordination of policies among the leading developed
countries for exchange rate stability. According to McKinnon1, the US, Germany and Japan
should have the optimal degree of exchange rate stability by fixing the exchange rates among
their currencies at the equilibrium level based on the purchasing power parity. Thus they would
co-ordinate their monetary policies for exchange rate stability. 2. Establishing Target Zones.
Williamson called for the establishment of target zones within which fluctuations in exchange
rates of major currencies may be permitted. According to him, the forces of demand and supply
should determine the equilibrium exchange rate. There should be an upper target zone of 10%
above the equilibrium rate and a lower target zone of 10% below the equilibrium exchange rate.
The exchange rate should not be allowed to move outside the two target zones by official

intervention. In February 1987, the leading five developed countries agreed under the Louvre
Agreement to have some sort of target zones for the stability of exchange rates among their
currencies. Despite official intervention by these countries, the exchange rates continued to
fluctuate within wide margins than agreed upon at Louvre. Thus Williamson‘s proposal has since
been discarded being impracticable. 3. Improving Global Liquidity. The reform package of the
present world monetary system should improve global liquidity. As a first step, both BOP deficit
and surplus countries should take steps to reduce a persistent imbalance through exchange rate
changes via internal policy measures. Second, they should also cooperate in curbing large flows
of ―hot money‖ that destabilise their currencies. Third, they should be willing to settle their BOP
imbalances through SDRs rather than through gold or dollar as reserve assets. Fourth, there
should be increasing flow of resources to the developing countries. 4. Leaning Against the Wind.
To reduce the fluctuations in exchange rates, the IMF Guidelines for the Management of
Floating Exchange Rates, 1974 suggested the idea of leaning against the wind. It means that the
central banks should intervene to reduce short-term fluctuations in exchange rates but leave the
long-term fluctuations to be adjusted by the market forces. 5. Richard Cooper suggests a global
central bank with a global currency which should be a global lender of last resort. 6. Jaffrey
Sachs proposes the creation of an international bankruptcy court which should deal with
countries. 7. George Soros opines that the IMF should set ceilings for external finance for each
country beyond which access to private capital need not be insured. But there should be
mandatory insurance by an international credit insurance corporation. 8. Paul Krugman suggests
reintroduction of capital controls as a ―least bad response‖ to an international crisis. 9. Objective
Indicators. To iron out exchange rate fluctuations, the IMF Interim Committee suggested the
adoption of such objective indicators as inflation-unemployment, growth of money supply,
growth of GNP, fiscal balance, balance of trade and international reserves. The variations in
these indicators require the adoption of restrictive monetary-fiscal measures to bring stability in
exchange rates. Conclusion. The various suggestions to reform the present monetary system are
closely inter-linked. But there is lack of unanimity over the various proposals among the nations.
Given the differences of opinion between the developing and developed countries and among the
developed countries themselves, there is no hope that any concrete proposal to reform the global
monetary system would be acceptable to nations. So the present system of managed floating
exchange rate is likely to stay on.

THE GENERAL AGREEMENT ON TARIFFS AND TRADE (GATT)
INTRODUCTION
The General Agreement on Tariffs and Trade (GATT) emerged from the ―ashes of the Havana
Charter‖. The world had experienced the rigours and problems of an extensive pattern of trade
barriers in the 1930s and during the Second World War. So the Allied Powers thought of having
a liberal world trading system after World War II. For this purpose, the International Conference
on Trade and Employment was held in Havana in the winter of 1947-48. Fifty-three nations drew
up and signed a charter for establishing an International Trade Organisation (ITO). But the US
Congress did not ratify the Havana Charter with the result that the ITO never came into
existence. Simultaneously, twenty-three nations agreed to continue extensive tariff negotiations
for trade concessions at Geneva which were incorporated in General Agreement on Tariffs and
Trade. This was signed on October 30, 1947 and came into force from January 1, 1948 when
other nations had also signed it. On January 1, 1995, the GATT disappeared and passed into
history when it was merged in the World Trade Organisation (WTO). 2. WHAT IS GATT? The
GATT was a multilateral treaty which had been signed by 96 governments known as
―contracting parties‖. Thirtyone other countries had applied GATT rules de facto. The GATT
was neither an organisation nor a court of justice. It was simply a multinational treaty which
covered 80 per cent of world trade. It was a decision making body with a code of rules for the
conduct of international trade, and a mechanism for trade liberalisation. It was a forum where the
contracting parties met from time to time to discuss and solve their trade problems, and also
negotiated to enlarge their trade. The GATT rules provided for the settlement of trade disputes,
called for consultations, waived trade obligations, and even authorised retaliatory measures. The
GATT was a permanent international organisation having a permanent Council of
Representatives with headquarters at Geneva. Its function was to call international conferences to
decide on trade liberalisation on a multilateral basis. 3. OBJECTIVES OF GATT The objectives
of the GATT were based on a few fundamental principles contained in the Code of International
Trade Conduct. 1. To follow unconditional most favoured-nation (MFN) principle. 2. To
carry on trade on the principle of non-discrimination, reciprocity and transparency. 3. To grant
protection to domestic industry through tariffs only. 4. To liberalise tariff and non-tariff
measures through multilateral negotiations. To achieve these objectives, the Agreement provided

for : (a) multilateral trade negotiations; (b) consultation, conciliation and settlement of disputes;
and (c) waivers to be granted in exceptional cases. The ultimate aim of establishing liberal world
trading system was to raise living standard, ensure full employment through a steadily growing
effective demand and real income, develop fully the resources of the world, and expand the
production and exchange of goods on global level.
4. PROVISIONS OF GATT The objectives and basic principles of the GATT could be viewed
from its various articles which are discussed as under :
1. MOST FAVOURED NATION CLAUSE To ensure non-discrimination, Article I dealt with
unconditional most favoured nation (MFN) clause for all import and export duties. The principle
of MFN implies that tariff preferences accorded by a country to another are extended to all others
with which it has trade relations. It also forbade the contracting parties from granting any new
preferences.
2. SCHEDULES OF TARIFF CONCESSIONS The most fundamental component of GATT was
a negotiated balance of mutual tariff concessions among contracting parties. The contracting
parties committed themselves not to raise import tariffs above the negotiated rates ―bound‖ in the
schedules of concessions, as incorporated in Article II of the Agreement. The bound tariff rates
negotiated were generalised to all contracting parties through the MFN principles. Thus the
GATT emphasised reciprocal and mutually advantageous arrangements among contracting
parties.
3. GENERAL ELIMINATION OF QUANTITATIVE RESTRICTIONS Article XI of the

Agreement prohibited or restricted the use of quantitative trade restrictions to trade. GATT
encouraged countries to fix a ceiling on their import duties at the lowest possible level.
4. EMERGENCY SAFEGUARD CODE
Article XIX of the GATT provided emergency safeguard code. Under this, a country could
impose a tariff or quota to restrain imports which ―caused or threaten serious injury‖ to domestic
producers.
5. EXCEPTIONS Articles XX and XXI provided ―General‖ and ―Security‖ exceptions towards
the prohibitions of import quotas by contracting parties. They were not directly related to the
need to afford protection to local industries. The six important exceptions were : One, a country
in balance of payments difficulties could introduce temporary quantitative restrictions, but under

MFN rule these must apply equally to imports from all sources. However, they must be limited
to the extent necessary to stop a serious decline, forestall a threatened decline in reserves, or
achieve a reasonable increase in abnormally low reserves. Two, underdeveloped countries were
allowed to apply quantitative restrictions to further their economic development, but only under
procedures approved by the GATT. Three, quantitative restrictions could also be applied to
agricultural or fishery products if domestic production of these articles was subject to equally
restrictive production or marketing controls. Four, the GATT allowed a country to take action if
products of other countries were imported at artificial low (dumped) or subsidised prices. Five, it
also allowed a country to introduce temporary ―safeguard‖ increases in protection when
industries were injured by sudden increase in imports. Six, Article XXIV permitted countries to
form customs or free trade areas among themselves, provided they were formed to facilitate trade
between the constituent territories and not to raise barriers to the trade of other contracting
parties.
6. RULES ON SUBSIDIES AND COUNTERVAILING DUTIES The rules on subsidies and
countervailing duties were incorporated in a separate code negotiated in the Tokyo round of the
1970s. Under these rules export duties on manufactured products were banned except for
developing countries. Export subsidies for primary products were restricted only by the condition
that they could not lead to acquisition or more than an equitable share of world export trade. The
Agreement also contained provisions that authorised importing countries to take compensating
action against trading partners found to be dumping goods in their markets or increasing rates
through exports subsidies. In the event of dumping, the importing country could impose anti-
dumping or countervailing duties whenever and to the extent that the sale of imported goods took
place in the importing country‘s market at less than its ―normal value‖ and resulted in mateial
injury to the domestic industry. Similary, the Agreement authorised an importing country to
impose offsetting countervailing duties on goods benefitting from production or export subsidies
in the exporting country, when these resulted in material injury to the domestic industry. But
such anti-dumping or countervailing duties should not result in net additional protection of the
affected industry in the importing country. In other words, these duties could not be imposed at
rates higher than were necessary to offset the margins
margins of dumping or subsidisation.

7. SETTLEMENT OF DISPUTES Under the GATT dispute settlement procedures complaints
could be brought against actions that violated the rules or impeded the objectives of the General
Agreement. The GATT relied on panels of three or five independent experts which made
findings and recommendations for adoption by the GATT Council. This procedure which
blended elements of third party adjudication and negotiation had successfully resolved disputes
among contracting parties.
5. GATT ―ROUNDS‖ OF GLOBAL TRADE NEGOTIATIONS Since 1947, seven ―rounds‖
(conferences) of global trade negotiations under the GATT had taken place, and the eighth, the
Punta Del Este (Uruguay) started in September 1986 and concluded on April 15, 1994. The first
conference on trade negotiations was held at Geneva in 1947, the second at Annecy (France) in
1949, the third at Torquay (England) in 1950-51, the fourth at Geneva (Switzerland) in 1955-56,
the fifth at Geneva between 1954-62 (Dillon
Round), the sixth at Geneva between 1963-67 (Kennedy Round), and the seventh at Tokyo
(Japan), between 1973-79. These conferences led to reduction or stabilisation of more than
60000 tariff rates, and to a number of non-tariff agreements among contracting parties having 80
per cent of the world trade. Since these ―rounds‖ are of academic interest, we shall briefly
discuss the Uruguay round which utlimately led to the formation of the World Trade
Organisation (WTO). THE URUGUAY ROUND The Eighth Round of GATT negotiations
which began at Punta Del Esta in Uruguay in September 1986 ought to have been concluded by
the end of 1990. But at the ministerial meeting in Brussels in December, 1990, an impasse was
reached over the area of agriculture and the talks broke down. The talks were restarted in
February 1991 and continued till August 1991. On December 20, 1991, Aurthur Dunkel, the then
Director-General of GATT tabled a Draft Final Act of the Uruguay Round, known as the Dunkel
Draft Text. This was a ―take-it-or-leave-it‖ document which was hotly discussed at various fora
in the member countries through 1992 till July 1993 when the then Director-General, Sutherland
relaunched the negotiations in Geneva. On August 31, 1993, the Trade Negotiations Committee
(TNC) passed a resolution to conclude the Uruguay Round by 15 December. On December 15,
1993 at the final session, chairman Sutherland declared that seven year of Uruguay Round
negotiations had come to an end. Finally, on April 15, 1994, 123 Ministers of member countries
ratified the results of the Uruguay Round at Marrakesh (Morocco) and the GATT disappeared
and passed into history and it was absorbed by the World Trade Organisation (WTO) on January

1, 1995. The Uruguay Round of trade negotiations undertaken by the GATT since its
establishment in 1947 had a wide agenda. The GATT originally covered international trade rules
in the goods sector only. Domestic policies were outside the GATT purview and it operated only
at international border. In the Uruguay Round, the GATT extended to three new areas, viz.,
intellectual property rights, services and investment. It also covered agriculture and textiles
which were outside the GATT jurisdiction. The Final Act embodying the results of the Uruguay
Round of Multilateral Trade Negotiations comprises 28 Agreements. It had two components : the
WTO Agreements and the Ministerial decisions and declarations. The WTO Agreement covers
the formation of the organisation and the rules governing its working. Its Annexures contain the
Agreements covering trade in goods, services, intellectual property rights, plurilateral trade,
GATT Rules 1994, disputes settlements rules and trade policy review. The Uruguay Round was
concerned with the two aspects of trade in goods and services. The First related to increasing
market access by reducing or eliminating trade barriers. This was met by reductions in tariffs,
reductions in non-tariff support in agriculture, the elimination of bilateral quantitative
restrictions, and reductions in barriers to trade in services. The second related to increasing the
legal security of the new levels of market access by strengthening and expanding rules and
procedures and institutions.
GAINS FROM URUGUAY ROUND The GATT Secretariat estimated the following gains as
the result of the Uruguay Round agreements and their implementation: 1. Income and Trade. The
estimated gains are : (1) $ 510 billion increase in annual world income by 2005;
(2) World trade in goods higher by $ 745 billion in the year 2005; (3) Largest increase in world
trade in goods by 60% in clothing, 20% in agriculture, forestry and fishery products, and 19% in
processed food and beverages; and (4) Increase in the exports and imports of the developing and
transition (the erstwhile Communist East European and U.S.S.R.) economies as a group by 50 %
above the average increase for the world trade as a whole. 2. Tariff Reduction. In the Uruguay
Round developed and developing countries abandoned several of their restrictive and
discretionary trade and industrial policy tools. As a result, there have been higher levels of tariff
―bindings‖. Binding means that they have ended the freedom to use the protectionist instruments
of the past. Tariff reductions and bindings had been as under : (1) Tariff bindings in developed
countries on industrial products increased from 78% to 99% and from 22% to 72% in developing
countries. (2) In agriculture, the bindings of the developed countries increased from 81% to

100% and of the developing countries from 22% to 100%. (3) Tariffs on industrial goods in
developed countries reduced from 6.3 to 3.9%. (4) Progress in reducing tariff escalation which
would benefit developing countries seeking to export more processed primary products. (5)
Above average tariff cuts for many products of export interest to developing countries. 3. Market
Access. There were several areas in the Uruguay Round that related to market access. The
important ones were tariffs, textiles and garments, and agriculture. (1) Tariffs. In developed
countries, industrial tariffs were reduced on an average to 4%. They are no longer significant
barriers to trade. Developing countries also reduced their tariffs considerably. The overall tariff
reductions in the Uruguay Round were an average of one-third. The value of industrial products
which enter the developed countries duty free under MFN increased from 20% to 44%. The
proportion of imports into developed countries from all sources with tariffs above 15%, declined
from 7 to 5% and from 9 to 5% for imports from developing countries. The market access also
increased through higher levels of tariff bindings on industrial products from 78% to 99% in
developed countries and from 22% to 72% in developing countries. (2) Textiles and Clothing.
The Textiles and Clothing Agreement also forms part of market access. A major achievement of
the Uruguay Round was the commitment to integrate this sector into a multilateral framework.
The integration of this sector into the GATT Rules, 1994 would take place in four phases by
January 1, 2005 when all products would be integrated. All MFA (Multi-Fibre Agreement)
restrictions existing on December 31, 1994 were carried over to the WTO Agreement and would
be removed when the products are gradually integrated into the GATT by January 1, 2005. As a
result, the exports of textiles and clothing from developing countries would increase manifold,
provided they are competitive. (3) Agriculture. The Agriculture Agreement contained minimum
market access commitment on agricultural products. It sought : (i) to open national markets to
world competition by replacing non-tariff barriers with normal customs duties; (ii) to check
overproduction in progressively reducing government aids, and (iii) to reduce subsidies
alongwith the volume of subsidised exports.
First the estimates by the GATT Secretariat revealed that the minimum market access
commitments on agricultural products subject to tariffication would create vast market
opportunities for among such important products as 1.8 m. tons of course grain, 1.1 m. tons of
rice, 0.8 m. tons of wheat, and 0.7 m. tons of dairy products. Second, a 36% reduction in export
subsidies and an 18% decline in domestic support to agricultural producers would further

increase market access. Lastly, the increase of tariff bindings from 81% to 100% in developed
countries and from 22% to 100% in developing countries, and no non-tariff barriers on
agricultural products would further enhance market access in these products. Thus the reductions
in tariffs on farm products and of subsidies to agriculture by the developed countries would make
the exports of developing countries more profitable. The terms of trade would, in turn, be in
favour of agriculture.
4. Rules and Disciplines*. The Uruguay Round also strengthened multilateral rules and
disciplines. The most important of these related to subsidies and countervailing measures,
antidumping, safeguards and disputes settlement. Rules concerning dispute settlement have been
made time bound, automatic and judicial in approach under the W.T.O.
5. TRIMs. Trade Related Investment Measures (TRIMs) prohibit investment measures that are
inconsistent with national treatment or general elimination of quantitative restrictions.
Developing countries have been given 5 years to phase out inconsisternt TRIMs and
developed countries 2 years. The TRIMs Agreement does not impose any obligation to
provide access to any particular sector for foreign investment.
6. GATS. The achievement of the Uruguay Round was the General Agreement on Trade in
Servics which is the first set of multilaterally agreed and legally enforceable rules and
disciplines relating to international trade in services. Services include financial,
telecommunications and services of natural persons. The GATS requires non-discrimination
by governments on the basis of Most Favoured Nation (MFN) clause and transparency in the
form of publication of all relevant laws and regulations relating to service trade.
7. TRIPs. The Uruguay Round also contained the Agreement on Trade Related Intellectual
Property Rights. It provides norms and standards for copyrights and related rights,
trademarks, geographical indications, industrial designs, patents, layout designs of integrated
circuits, trade secrets and protection of undisclosed information. The Agreement allowed one
year for developed countries, 5 years for developing and 11 years for least developed
countries to change their laws for the implementation of TRIPs. The TRIPs Agreement on
patents would be able to tap the generic market in the USA and is expected to generate new
business worth billions of dollars by the turn of the century and similar opportunities in the
EEC for developing countries like India. They would also gain from the inflow of better

technology and create a better climate for research and development in agriculture and
pharmaceuticals.
As a result, the quality of products available in the market will improve. For instance, if the
farmers can get better quality seeds from multinationals even at higher prices and improve and
increase their produce substantially, they stand to gain. Similar will be the case with national
drug manufacturers in developing countries when they establish strategic linkages for
development of their new discoveries in drugs.
8. GATT AND DEVELOPING COUNTRIES Before the Kennedy Round (1964-67),
developing countries gained very little from the GATT except that they could use
quantitative restrictions to correct disequilibrium in balance of payments and benefitted from
tariff reduction by developed countries. But the principle of reciprocity for trade concessions
went against the developing countries, because they were unable to provide equivalent
benefits to the developed countries. For instance, tariffs on total manufactured imports by
developed countries averaged 11 per cent but were 17 per cent on those from developing
countries. Moreover, GATT did not take any initiative on trade barriers on agricultural and
tropical products of developing countries. The concept of ―special and preferential‖ treatment
for developing countries was formally introduced into the General Ageement in 1957. Under
it, negotiations would take in account their needs for a more flexible use of tariff protection
to assist their economic development and the special needs of these countries to maintain
tariffs for revenue purposes. On the recommendations of the Haberler Report, the GATT
started an action programme in 1958 which recommended that the developed countries
should reduce taxation and trade barriers on industrial and primary products of developing
countries.
In 1963, the contracting parties agreed on a more flexible attitude towards them. Accordingly,
tariffs on some tropical products like tea and timber were reduced or eliminated by developed
countries. In 1965, a new Part IV on Trade and Development was incorporated into the General
Agreement dealing with the principle on non-reciprocity for developing countries. The Kennedy
Round (1964-67) bestowed some benefits on developing countries when thirty-seven developed
countries reduced tariffs on manufactured goods. But little attention was paid to the problems of
developing countries. In 1970, the Generalised System of Preferences (GSP) was introduced
which permitted developed countries to grant unilateral tariff preference to developing countries.

In June 1971, GATT waived the MFN treatment obligation for developed countries for a period
of ten years to the extent needed to grant preferential treatment under the GSP which has since
been extended further. It was, however, in the Tokyo Round (1973-79) that a number of
agreements on subsidies and countervailing duties covering agricultural, fisheries and forestry
products; on customs valuation; on government procurement; on technical barriers to trade; on
import licensing; on dairy products; on bovine meat; and on civil aircraft were reached. It was a
triumph for developing countries for these agreements contained special provisions for
developing countries. The Tokyo Round also led to trade concessions to the exports of raw,
processed, and semi-processed tropical products of developing countries by developed countries.
However, trade in textiles and clothing has been subjected to special restrictions for nearly four
decades by developed countries outside the GATT rules. Developing countries, being the
principal exporters of these goods, have been at a disadvantage in this respect. The early 1960s
witnessed the advent of the Short-term Arrangement on Cotton Textiles in 1961-62 and the
Long-term Arrangement from 1962-73 restricted trade in cotton textiles on the plea that
developed countries which are the principal importers, need special protection against ―market
disruption‖ by lower-cost developing country suppliers. The market disruption is claimed by
developed countries under Article XIX of GATT. In 1974 the first Multifibre Arrangement
(MFA I) was negotiated between the developed and developing countries for a period of four
years which was renewed in 1978 (MFA II) and in 1982 (MFA III). MFA IV was renewed in
1986 for a period of five years. The renewed MFA was potentially more restrictive than the
previous ones. It contained the right of the developed importing country to cut imports of
specific products from particular developing countries on a selective basis when it was feared
that too many imports capable of market disruption of local products might occur. The most
significant change in MFA IV was that it extended its coverage from cotton, wool and man-made
fibres to all vegetable fibres as well as silk mixed with cotton, wool or man-made fibres. For the
first time, a return to GATT rules was written into the MFA. But it made no mention of phasing
out the MFA or setting a time limit within which the final objective of application of GATT rules
to trade in textiles would be attained. Under the Uruguay Round, textiles and clothing would be
integrated into a multilateral framework. The integration of this sector into the GATT Rules
1994 would take place in four phases by January 1, 2005, when all products would be integrated.
As a result, all MFA restrictions would be removed by that date. For other benefits to developing

countries under the Uruguay Round refer to the previous section on Uruguay Round. Despite
special and preferential treatment for developing countries provided in the GATT rules, they are
being discriminated under the ―escape clauses‖ and ―safeguard‖ rules of the GATT. Moreover,
the multiplication of trade restrictions outside the GATT rules, such as ―voluntary export
restraints‖, and ―orderly marketing agreements‖ go against the interest of developing countries
and undermine the utility of the General Agreement under the Uruguay Round.
CRITICISMS OF GATT There had been large scale evasion of GATT rules1 by contracting
parties over the years which made a mockery of the GATT. From the beginning of the GATT,
agriculture was treated as a special case where GATT rules hardly applied. Almost every
developed country followed such agricultural trade policies which were inconsistent with the
GATT rules. It was only at the Kennedy Round and the Tokyo Round that a few agreements
were arrived at relating to agricultural and
dairy products. But trade liberalisation for agricultural products has much less than for
manufactures. Producers of agricultural products have been resorting to domestic support
policies leading to surplus production that can be exported only with the help of heavy subsidies.
For example, European countries have been exporting subsidised wheat, while the US has placed
import restrictions on dairy products. No doubt, developed countries have removed the majority
of tariff barriers, yet they have been reluctant to abolish others. Rather, they have devised new
trade restrictions under the garb of ―voluntary export restraints‖, ―low-cost suppliers‖, ―market
disruption‖ etc. which are outside the GATT rules. They are applied against developing and state
trading countries and Japan. For instance, such restrictions affect over 50 per cent of the French
imports and 45 per cent of the United States. The GATT‘s role was being undermined by
concluding bilateral, discriminatory and restrictive arrangements outside the GATT rules. The
EEC and the US have placed many import restrictions on innumerable products from Brazil,
HongKong, Korea, and a host of other developing countries, countries, besides Japan, after
bilateral negotiations. At present, over 100 MFA type bilateral agreements are in force in the
world which restrict exports of developing countries to the developed ones. The increasing use of
subsidies had been another important factor in side-tracking the GATT. This is because GATT‘s
rule on subsidies are not explicit. The GATT rules permitted domestic subsidies but they led to
retaliation if they damaged the trade interests of other countries. The result has been further
worsening of open trade. The ―safeguard‖ rules under Article XIX of the GATT allowed the

contracting parties to grant protection in case of need, such as injurious dumped or subsidised
imports, or in severe balance of payments difficulties. But all temporary restrictions permitted
under the escape clause have become permanent features of the world trading system. The
GATT rules in Article XXIV which permitted the formation of customs unions and free-trade
areas had been distorted and abused. These rules left many ambiguities which seriously
weakened the GATT. ―They had set a dangerous precedent for further special deals,
fragmentation of the trading system, and damage of the trading interests of non-participants.‖ As
a result, the benefits of MFN rule failed to spread uniformly among the contracting parties.
7. The GATT being a mandatory body did not possess any mechanism to get its rules
implemented by contracting parties. The procedure for dispute settlement consisted of a
panel of three to five independent experts whose recommendations had no legal binding. This
was a serious weakness of the GATT.
8. It was perhaps due to these inherent loopholes in the working of GATT that as much as 80
per cent of world trade was being conducted outside the GATT rules. Despite these
criticisms, 125 countries operated under the GATT rules, while the remaining countries of
the world benefitted from them under the umbrella of the MFN rule.
THE WORLD TRADE ORGANISATION (WTO)

INTRODUCTION
The Uruguay Round of GATT negotiations concluded on April 15, 1994 at Marrakesh,
Morocco. India, alongwith 123 Ministers besides the EC countries signed the Final Act
incorporating the Eighth round of multilateral trade negotiations. The Final Act consists of :
(1) the WTO Agreement which covers the formation of the organisation and the rules
governing its working; and (2) the Ministerial decisions and declarations which contain the
important agreements covering trade in goods, services, intellectual property and plurilateral
trade. They also contain the dispute settlement rules and trade policy review system. The
WTO Agreement is in fact the Uruguay Round agreements whereby the original GATT is
now a part of the WTO Agreement which came into force from January 1, 1995.
2. THE WTO The WTO is the successor to the GATT. The GATT was a forum where the
member countries met from time to time to discuss and solve world trade problems. But
the WTO is a properly established permanent world trade organisation. It has a legal

status and enjoys privileges and immunities on the same footing as the IMF and the
World Bank. It includes : (1) the GATT, as modified by the Uruguay Round; (2) all
agreements and arrangements concluded under the GATT; and (3) the complete results of
the Uruguay Round.
There were 77 member countries of the WTO on January 1, 1995. Now there are 151
members. India is one of the founder members.
3. DIFFERENCE BETWEEN GATT AND WTO The WTO is not an extension of the
GATT but successor to the GATT. It completely replaces GATT and has a very different
character. The major differences between the two are the following : The GATT had no
legal status whereas the WTO has a legal status. It has been created by international
treaty ratified by the governments and legislatures of member states. It has a global status
similar to that of the IMF and the World Bank. But unlike them, it is not an agency of the
UN, although it has a ‗cooperative relationship‘ with the UN. The GATT was a set of
rules and procedures relating to multilateral agreements of a selective nature. There were
separate agreements on separate issues which were not binding on members. Any
member could stay out of an agreement. Only those who signed the agreement could be
penalised on default. The agreements which form part of the WTO are permanent and
binding on all members. Action can be taken against any defaulting member by all the
member states. The GATT dispute settlement system was dilatory and not binding on the
parties to the dispute. The WTO dispute settlement mechanism is automatic, faster and
binding on the parties. The Dispute Settlement Board of the WTO in its first decision
brought the mighty US to accept its verdict. Thus the WTO has teeth whereas the GATT
was toothless. The GATT was a forum where the member countries met once in a decade
to discuss and solve world trade problems. There used to be long, protracted negotiating
rounds which took decades to complete. The WTO, on the other hand, is a properly
established rule-based world trade organisation where decisions on agreements are time
bound. The dateline can be extended only by consensus. The GATT rules applied to trade
in goods. Trade in services was included in Uruguay Round but no agreement was
arrived at. The WTO covers not only trade in goods and services but also trade-related
aspects of intellectual property rights and a number of other agreements.

The GATT had a small secretariat managed by a Director General. But the WTO has a
large secretariat and a huge organisational set-up.
4. ITS STRUCTURE The structure or organisation of the WTO is headed by the
Ministerial Conference composed of representatives of all the members which meet at
least once every two years. It carries out the functions of the WTO and takes actions
necessary to this effect. It takes decisions on all matters under any of the Multilateral
Trade Agreements. The Ministerial Conference is the supreme authority of the WTO.
There is the General Council composed of representatives of all the members to oversee
the operation of the WTO Agreement and ministerial decisions on a regular basis. It also
acts as a Dispute Settlement Body (DSB) and a Trade Policy Review Body (TPRB), each
having its own Chairman. The General Council sits in Geneva on an average of once a
month. There is the Council for Trade in Goods, the Council for Trade in Services and
the Council for Trade-Related Aspects of Intellectual Property Rights (TRIPs) which
operate under the General Council. These Councils, in turn, have their subsidiary bodies.
The Councils and subsidiary bodies meet as necessary to carry out their respective
functions. There is the Committee on Trade and Development, the Committee on Balance
of Payments Restrictions and the Committee on Budget, Finance and Administration
which carry out the functions assigned to them by the WTO Agreement, the Multilateral
Trade Agreements and any additional function assigned to them by the General Council.
The Secretariat of the WTO is headed by the Director General. The Ministerial
Conference appoints the Director General and sets out his powers, duties, conditions of
service and terms of office. The Director General is appointed for a four-year term. He
has four deputies from different member states. The Director General appoints the
members of staff of the Secretariat and determines their duties and conditions of service
in accordance with the regulations adopted by the Ministerial Conference. The Director
General presents to the Committee on Budget, Finance and Administration, the annual
budget estimates and financial statement of the WTO. The Committee, in turn, reviews
the annual budget estimates and the financial statement and makes recommendations to
the General Council for final approval. The General Council adopts the annual budget
estimates and financial statements by a two-third majority comprising more than half the
members of the WTO. The financial regulations relating to the scale of contributions and

the budget are based on the rules and practices of the GATT. The WTO continues the
practice of decision-making by consensus, as followed under the GATT 1947. Where a
decision cannot be arrived at by consensus, the matter at issue is decided by 2/3rd
majority voting on the basis of ―one country, one vote‖. But in the case of interpretation
of the provisions of the agreements and waiver of a member‘s obligations, the majority
required is 3/4th of the members. However, amendments relating to general principles,
such as MFN treatment must be approved by all members. 5. ITS OBJECTIVES In its
Preamble, the Agreement establishing the WTO lays down the following objectives of
the WTO: Its relations in the field of trade and economic endeavour shall be conducted
with a view to raising standards of living, ensuring full employment and large and
steadily growing volume of real income and effective demand, and expanding the
production and trade in goods and services. To allow for the optimal use of the world‘s
resources in accordance with the objectives of sustainable development, seeking both (a)
to protect and preserve the environment, and (b) to enhance the means for doing so in a
manner consistent with respective needs and concerns at different levels of economic
development. To make positive efforts designed to ensure that developing countries,
especially the least developed among them, secure a share in the growth in international
trade commensurate with the needs of their economic development. To achieve these
objectives by entering into reciprocal and mutually advantageous arrangements directed
towards substantial reduction of tariffs and other barriers to trade and the elimination of
discriminatory treatment in international trade relations. To develop an integrated, more
viable and durable multilateral trading system encompassing the GATT, the results of
past liberalisation efforts, and all the results of the Uruguay Round of multilateral trade
negotiations. To ensure linkages between trade policies, environmental policies and
sustainable development.
6. ITS FUNCTIONS The following are the functions of the WTO: It facilitates the
implementation, administration and operation of the objectives of the Agreement and of
the Multilateral Trade Agreements. It provides the framework for the implementation,
administration and operation of the Plurilateral Trade Agreements relating to trade in
civil aircraft, government procurement, trade in dairy products and bovine meat. It
provides the forum for negotiations among its members concerning their multilateral

trade relations in matters relating to the agreements and framework for the implemenation
of the results of such negotiations, as decided by the Ministerial Conference. It
administers the Understanding on Rules and Procedures governing the Settlement of
Disputes of the Agreement.
It co-operates with the IMF and the World Bank and its affiliated agencies with a view to
achieving greater coherence in global economic policy-making.
7. WTO AGREEMENT The Agreement establishing the WTO consists of the following
which embody the results of the Uruguay Round of the Multilateral Trade Negotiations:
Multilateral Agreements on Trade in Goods : GATT Rules 1994. General Agreements on
Trade in Services. Agreement on Trade-Related Aspects of Intellectual Property Rights
(TRIPs). Understanding on Rules and Procedures governing the Settlement of Disputes.
Plurilateral Trade Agreements. Trade Policy Review Mechanism. They are discussed as
under :
1. MULTILATERAL AGREEMENTS ON TRADE IN GOODS The general agreement
on trade in goods defines the GATT 1994 and includes various agreements dealing with
different aspects related to trade in goods. (1) GATT 1994 The GATT 1994 includes
GATT 1947 as amended up to January 1, 1995 when the WTO Agreement came into
force. It also includes the provisions of specified legal instruments, the Marrakesh
Protocol to GATT 1994 and the following understandings : (a) Article II : 1(b) of GATT
1994. To ensure transparency of the legal rights and obligations, the nature and level of
any ―other duties or charges‖ levied on bound tariff items in the Schedules of concessions
continue with effect
from April 15, 1995. (b) Article XVII of GATT. To ensure transparency of the activities
of state trading enterprises, members are required to notify such enterprises to the
Council for Trade in Goods for review by the working party atleast once a year and report
to the Council. (c) Understanding on Balance of Payment Provisions of GATT. Members
imposing restrictions for purposes of balance should do so in the least disruptive manner.
They should give preference to price-based measures like import surcharges, import
deposits or measures which affect the price of imported goods. They should avoid the
imposition of ―new‖ quantitative restrictions and should publicly announce ―as soon as
possible‖ time schedules for the removal of restrictive import measures for purposes of

balance of payments. The Committee on Balance of Payments Restrictions carries out
consultations in order to review all restrictive import measures taken for balance of
payments purposes. (d) Article XXIV of GATT 1994. The Agreement on Customs
Unions and Free Trade Areas clarifies and reinforces the criteria and procedures for the
review of new or enlarged customs unions or free trade areas and for the evaluation of
their effects on third parties. The Agreement also clarifies the procedure for any
compensatory adjustment in the event of contracting parties forming a customs union
seeking to increase a bound tariff. (e) Understanding on the Interpretation of Article
XXVIII. Article XXVIII covers modification of GATT Schedules. It lays down new
procedures for the negotiation of compensation when tariff bindings are modified or
withdrawn. (2) AGREEMENT ON AGRICULTURE The Agreement on Agriculture
relates to domestic subsidies, export subsidies (including volume of subsidised exports),
minimum market access commitment, domestic support, sanitary and phytosanitary and
food aid operations. The Agreement seeks to open national markets to international
competition by replacing non-tariff measures with normal customs duties that would be
progressively reduced. Second, it seeks to check overproduction by progressively
reducing government aids that encourage overproduction and hence surpluses which are
either disposed of through export subsidies or destroyed. Third, it seeks new disciplines
on export competition and reduction in subsidies alongwith the volume of subsidised
exports.
(i) Domestic Subsidies. Domestic subsidies fall into two categories : (a) non-product
specific subsidies given for all crops which include subsidies given for fertilisers, water,
electricity, seeds and credit; and (b) product-specific subsidies given for specific crops, as
in India in the form of minimum support price for some agricultural crops. For the
purpose of calculating total subsidies given to farmers, known as the Total Aggregate
Measurement of Support or Total AMS, both types of subsidies mentioned above must be
totalled together. Such total in any year, called the Current Total AMS, should not exceed
10 per cent of the
value of total agricultural production in that year in the case of a developing country to be
exempt from any obligation to reduce its subsidies. The subsidy is to be calculated at the
international price for the commodity. (ii) Export Subsidies. WTO members are required

to reduce the value of direct export subsidies to a level of 36 per cent below the 1986-90
base period level over the six-year implementation period, and the quantity of subsidised
exports by 21 per cent over the same period. In the case of developing countries, the
reductions are 2/3rd those of developed countries over a ten-year period. But no
reductions apply to the least developed countries.
(iii) Minimum Market Access Commitment. The minimum market access commitment
applies to those countries that maintain restriction of various types on agricultural
imports, and are, therefore, required to convert those restrictions into tariffs and reduce
those tariffs by 36 per cent over the six-year period. Such countries are also required to
allow a minimum market access opportunity of 3 per cent of their domestic consumption
for foreign agricultural consumption for six years which will rise to 5 per cent after that
period. These commitments apply only if a country is obliged to render its import
controls in terms of tariffs. In the case of
developing countries, tariffs on agricultural products are to be reduced by 24 per cent
over a period of ten years. Least developed countries are not required to reduce their
tariffs. (iv) Domestic Support. Domestic support measures that have a minimum impact
on trade, known as green box policies are excluded from reduction commitments. Such
policies include general government services, such as in the areas of research, disease
control, infrastructure and food security. It includes direct payments to producers in the
form of income support, structural adjustment assistance, direct payments under
environmental programmes and under
regional assistance programmes. In addition, there are other policies which are not to be
included in the Total Average Measurement of Support (Total AMS) reduction
commitments. They are direct payments under production limiting programmes, certain
government assistance measures to encourage agricultural and rural development in
developing countries and other support measures. These should make up only 10 per cent
of the value of production of individual products or of the total agricultural production in
the case of developed countries and 5 per cent in the case of developed countries.
(v) Sanitary and Phytosanitary Measures. The application of sanitary and phytosanitary
measures concern food safety, and animal and plant health measures. The agreement
recognises that governments have the right to take sanitary and phytosanitary measures in

order to protect human, animal or plant life or health. But they should not arbitrarily or
unjustifiably discriminate between members where identical or similar conditions prevail.
The agreement seeks to ensure that animal and plant health and safety measures do not
serve as unwarranted trade barriers. The agreement lays down procedures and criteria for
the assessment of risk and determination
of appropriate levels of sanitary or phytosanitary protection. (vi) Food Stocking and Food
Aid. The agreement recognises that during the interim period least developed and net
food-importing developing countries may experience negative effects with respect to
supplies of food imports. It, therefore, sets out objectives with regard to the provision of
food aid and basic foodstuffs in full grant form and aid for agricultural development. It
also refers to the possibility of short-term financing of commercial food imports by the
IMF and the World Bank. A Committee on Agriculture has been established to monitor
and review the implementation of the provision of the Agriculture Agreement.
(3) AGREEMENT ON TEXTILES AND CLOTHING The objective of this Agreement
is to secure the integration of the textiles and clothing sector into the GATT 1994. The
integration of this sector would take place in four phases. First, on January 1, 1995 each
party was integrated into GATT products from the specific list in the Agreement which
accounted for not less than 16 per cent of its total volume of imports in 1990. In the
second phase beginning January 1, 1998, products which accounted for not less than 17
per cent of 1990 imports would be integrated. In the third phase beginning January 1,
2002, products which accounted for not less than 18 per cent of 1990 imports would be
integrated. All remaining products would be integrated at the end of the transition period
on January 1, 2005 in the fourth phase. Integration means that trade in tops and yarns,
fabrics, made-up textiles products, and clothing will be governed by the General Rules of
GATT. All MFA (Multi-Fibre Agreement) restrictions existing on December 31, 1994
have been carried over into the new Agreement and would be maintained until such time
as the restrictions are removed or the products integrated into the GATT. In the case of
non-MFA restrictions maintained by some members, they would also be brought within
the purview of the GATT 1994 within one year of the coming of the Agreement into
force or phased out progressively by 2005. There is a specific transitional safeguard
mechanism for products not yet integrated into the GATT 1994 at any phase. Action can

be taken against an individual exporting country if it is found by the importing country
that overall imports of a product were entering the country in such large quantities as to
cause serious damage to the relevant domestic industry. Action under the safeguard
mechanism can be taken either by mutual agreement following consultations or
unilaterally but subject to the review of the Textile Monitoring Body. Safeguard restraints
can be in operation for up to three years without extension or until the product is
integrated into the GATT. As part of the integration process, all members shall take such
actions in the area of textiles and clothing as may be necessary so as to follow GATT
Rules and improve market access and ensure the application of policies relating to fair
and equitable trading conditions and avoid discrimination against imports.
(4) AGREEMENT ON TECHNICAL BARRIERS TO TRADE This Agreement extends
and clarifies the Agreement on Technical Barriers to Trade reached in the Tokyo Round.
It seeks to ensure that technical negotiations and standards, and testing and certification
procedures do not create unnecessary obstacles to trade. However, it recognises that
countries have the right to establish protection on human, animal or plant life or health or
the environment. A Code of Good Practice for the Preparation, Adoption and Application
of Standards
Standards by standardising bodies has been included into the Agreement.
(5) AGREEMENT ON TRADE RELATED ASPECTS OF INVESTMENT
MEASURES (TRIMS)
It calls for the removal of all trade related investment measures within a period of five
years. These measures are confined to quantitative restrictions and national treatment. In
particular, they relate to such measures as investment in identified areas, level of foreign
investment for treating foreign companies at par with national companies, export
obligations, and use of local raw materials. It prevents the imposition of any performance
clauses on foreign investors in respect of earnings of foreign exchange, foreign equity
participation, and transfer to technology. It requires foreign investment companies to be
treated at par with national companies. It prevents the imposition of restrictions on areas
of investment. It requires free import of raw materials, components and intermediates.
The Agreement recognises that certain investment measures restrict and distort trade. It,
therefore, requires mandatory notification of all non-confirming TRIMs and their

removal within two years for developed countries, within five years for developing
countries and within seven years for least developed countries. It establishes a Committee
on TRIMs which will monitor the implementation of these commitments and report to the
Council of Trade in Goods annually. (6) AGREEMENT ON ANTI-DUMPING Article
VI of the GATT provides for the right of contracting parties to apply anti-dumping
measures if dumped imports cause injury to a domestic industry in the importing member
country. The revised Agreement is an improvement over the Tokyo Round Agreement. It
provides greater clarity, more detailed rules and the criteria to be taken into account for
determining injury caused by dumped imports to domestic industry, the procedure to be
followed in initiating and conducting anti-dumping investigations, and the
implementation and duration of anti-dumping measures, and dispute settlement relating
to anti-dumping actions taken by domestic authorities. Under the new rules, an anti-
dumping investigation should be immediately terminated if the ―margin of dumping‖ is
less than 2 per cent of the export price or the volume of dumped imports from a particular
country is less than 3 per cent of the total imports of that product subject to a ceiling of 7
per cent of all such dumped imports.
(7) AGREEMENT ON SUBSIDIES AND COUNTERVAILING MEASURES (SCM)
The SCM Agreement applies to non-agricultural products. It classifies subsidies into
prohibitive non-actionable and actionable categories like the traffic lights—red, green
and amber, respectively. The prohibitive (red) category includes subsidies with high
trade-distorting effects. They are export subsidies and those that favour the use of
domestic over imported goods. Developing countries having a per capita income of less
than $ 1,000, have been exempted from the prohibition of export subsidies. The non-
actionable (green) subsidies are those that are not specific to an enterprise or industry or a
group of enterprise or industries. Actionable (amber) industries are neither red nor green.
They are actionable by a trading partner if its interests are adversely affected. It can seek
remedy by having countervailing duties or follow the dispute-settlement procedures.
Developing countries have been exempted from certain subsidy practices such as
investment subsidies, agricultural input subsidies generally available to low income or
resource-poor farmers, and measures to encourage diversification from growing illicit
narcotic crops. The Multilateral Agreement on Trade in Goods also includes agreements

on Customs Valuation, Pre-shipment Inspection, Rules of Origin, Import Licensing
Procedures and Safeguards. 2. GENERAL AGREEMENTS ON TRADE IN SERVICES
(GATS) This Agreement covers all internationally traded services. Foreign services and
service suppliers would be treated on equal national footing with domestic services and
service suppliers. However, governments may indicate specific Most-Favoured Nation
(MFN) exemptions which will be reviewed after 5 years, with a normal limitation of 10
years. It requires transparency which includes the publication of all relevant laws and
regulations relating to services trade. International payments and transfers relating to
trade in services shall not be restricted, except in the event of balance of payments
difficulties where such restrictions will be temporary, limited and subject to conditions.
Any liberalisation of trade in services would be progressive in character. It would be
through negotiations at five-year intervals in order to reduce or remove the adverse
effects of measures on trade in services and to increase the general level of specific
commitments by governments. The Agreement sets out special conditions relating to
individual sectors. So far as the movement of natural persons is concerned, it permits the
governments to negotiate specific commitments applicable to the temporary stay of
people for the purpose of providing a service. It does not apply to persons seeking
permanent employment or residence in a country. In financial services, it establishes the
right of goverments to take appropriate measures for the protection of investors,
depositors and policy holders, and to ensure the integrity and stability of the financial
system. They came into effect 6 months after WTO came into force. In
telecommunications, the Agreement requires a Member to establish, construct, acquire,
lease, operate or supply telecommunications transport networks and services and make it
available to the public. However, a developing country may place reasonable conditions
on access to and use of public telecommunica-tions, transport networks and services to
strengthen its domestic telecommunica-tions infrastructure and service capacity and to
increase its participation in international trade in telecommunications services in co-
operation with the International Telecommunication Union and the International
Organisation for Standardisation. The GATS will also apply to aircraft repair and
maintenance services, marketing of air transport services and computer reservation
services. The governments have agreed to set up working parties on : (1) Trade in

services and environment to examine and report, with recommendations, on the
relationship between services trade and environment, including the issue of sustainable
development. (2) Professional services to examine and report, with recommendations, on
the disciplines necessary to ensure that measures relating to qualifications requirements
and procedure, technical standards and licensing requirements in the field of professional
services do not constitute unnecessary barriers to trade. The GATS also contains
consultations and dispute settlement and the establishment of a Council on Services.
3. AGREEMENT ON TRADE-RELATED ASPECTS OF INTELLECTUAL
PROPERTY RIGHTS (TRIPS) The TRIPs Agreement covers seven categories of
intellectual property : (1) copyright and related rights; (2) trademarks; trademarks; (3)
geographical indications; (4) industrial designs; (5) patents which also include micro-
organisms and plant varieties; (6) integrated circuits; and (7) trade secrets. We discuss
them briefly as under : (1) Copyright and Related Rights. The parties are required to
comply with the Berne Convention for the protection of literary and artistic works.
Computer programmes are included in literary works. Authors of computers programmes,
performers on a phonogram, producers of phonograms (sound recordings) and
broadcasting organisations are to be given the right to authorise or prohibit the
commercial rental of their works to the public. A similar exclusive right applies to films.
The protection for performers and producers of sound recordings are to be for no less
than 50 years and for broadcasting organisations for atleast 20 years. (2) Trademarks.
Any sign, or any combination of signs, capable of distinguishing the goods or services of
one undertaking from those of other udertakings constitutes a trade mark. Such signs, in
particular words including personal names, letters, numerals, figurative elements and
combinations of colours as well as combinations of such signs are eligible for registration
as trademarks. The owner of a registered trademark has the exclusive right to prevent all
third parties not having the owner‘s consent from using in the course of trade identical or
similar signs for goods or services. Initial registration, and each renewal of registration,
of a trademark is for a term of no less than seven years. The registration of a trade mark is
renewable indefinitely. (3) Geographical Indications. Geographical indications refer to
the indentity of a good as originating in the territory of a Member, or a region or locality
in that territory where a given quality or reputation of the good is essentially attributed to

its geographical origin. Members are required to provide the legal means for interested
parties to prevent the use of any indication which misleads the consumer as to the origin
of goods and any use which would constitute an act of unfair competition. Additional
production is applied for geographical indications for wines and spirits. (4) Industrial
Designs. Industrial designs are protected for a period of 10 years. Owners of protected
designs would be able to prevent the manufacture, sale or importation of articles bearing
or embodying a design which is a copy of the protected design for commercial purposes.
The duration of protections available shall be for at least 10 years.
(5) Patents. Patents shall be available for any inventions, whether products or processes,
in all fields of technology, provided they are new, involve an inventive step and are
capable of industrial application. Patent owners shall have the right to assign, or transfer
by succession, the patent and to conclude licensing contracts. The Agreement requires
20-year patent protection. Inventions may be excluded from patentability if their
commercial exploitation is prohibited for reasons of public order or morality. Further,
diagnostic, therapeutic and surgical methods for the treatment of humans or animals,
plants and animals other than micro-organisms, and essentially biological processes for
the production of plants or animals other than non-biological and microbiological
processes may be excluded from patentability. However, members shall provide for the
protection of plant varieties either by patents or by an effective sui generis system
(breeder‘s rights) or by any combination thereof. These provisions shall be reviewed 4
years after January 1, 1995.
(6) Integrated Circuits. The TRIPs Agreement provides protection to the layout-designs
(topographies) of integrated circuits for a period of 10 years. But the protection shall
lapse 15 years after the creation of the layout-design. (7) Trade Secrets. Trade secrets and
know-how having commercial value shall be protected against breach of confidence and
other acts. Test data submitted to governments in order to obtain marketing approval for
pharmaceuticals or agricultural chemicals shall be protected against unfair commercial
use. Lastly, this Agreement refers to the controls of anti-competitive practices in
contractual licenses pertaining to intellectual property rights. It provides for consultations
between governments in order to protect intellectual property rights from being absued.
The Agreement requires a one-year transition period for developed countries to bring

their legislation and practices into conformity for the implementation of TRIPs.
Developing countries and the erstwhile East-European and U.S.S.R. countries would
have a 5-year transition period and the least developed countries 11 years. Those
developing countries which do not provide product patent protection have been given 10
years. The Agreement also envisages the establishment of a Council for Trade-Related
Aspects of Intellectual Property Rights to monitor the operations of the Agreements and
Governments‘ compliance with it.
4. DISPUTE SETTLEMENT SYSTEM The Understanding on Rules and Procedures
Governing the Settlement of Disputes shall apply to consultations and the settlement of
disputes between Members concerning their rights and obligations under the provisions
of the Agreement establishing the WTO. For this purpose, a Dispute Settlement Body
(DSB) will be established. The first stage in the settlement of disputes is the holding of
consultations between the members concerned. If consultations fail and if both parties
agree, the Director General of WTO offers good offices, conciliations and mediation. The
complainant member can ask the DSB to establish a panel of three experts within 30
days. There is also the provision of the appellate review by a standing Appellate Body of
seven members to be established by the DSB who will report to the DSB between 60-90
days. The DSB will adopt the report within 30 days which will be unconditionally
accepted by the parties to the dispute.
5. PLURILATERAL TRADE AGREEMENTS (PTA) The Plurilateral Trade
Agreements consist of the Agreement on Trade in Civil Aircraft, Agreement on
Government Procurement, International Dairy Agreement and International Bovine Meat
Agreement. The first Agreement was done at Geneva in April 1979, as subsequently
modified, rectified or amended. The latter three Agreements were done at Marrakesh on
April 15, 1994.
6. TRADE POLICY REVIEW MECHANISM (TPRM) The TPRM aims to carry out
reviews of the trade policies and practices under the Multilateral Trade Agreements and
the Plurilateral Trade Agreements for the smoother functioning of the multilateral trading
system. For this purpose, it envisages the establishment of the Trade Policy Review Body
(TPRB). In order to achieve full transparency, each member shall report regularly to the
TPRB about the trade policies and practices pursued by it. An annual overview of

developments in the international trading environment having an impact on the
multilateral trading system shall also be undertaken by the TPRB. The overview shall be
assisted by an Annual Report by the Director General setting out major activities of the
WTO and highlighting significant policy issues affecting the multilateral trading system.
8. CRITICAL APPRAISAL OF URUGUAY ROUND AND WTO AGREEMENT The
Uruguay Round took eight long years of negotiations by the contracting countries. The
legal document comprising the Final Act of the results of the Uruguay Round of
Multilateral Trade Negotiations contains 28 Agreements. The Uruguay Round was larger
in scope and coverage than the earlier Rounds and for the first time covered areas like
services, agriculture, intellectual property rights and investments. It also emphasised
linkages between trade policies, environmental policies and sustainable development
through the WTO. The replacement of the GATT, as a discussion forum by the WTO, as
a permanent world trade organisation, was a spectacular achievement of the Uruguay
Round. The WTO contains not only the original GATT as amended by the Uruguay
Round but also a number of new Agreements discussed above. These Agreements are
likely to benefit the developing and least developed countries in the long-run, provided
they receive full cooperation from the developed countries in their efforts towards
globalisation. However, there are many loopholes in these Agreements which are likely
to be to the disadvantage of the developing countries.
1. Agriculture. The Agreement on agriculture would harm the interests of farmers in
developing countries. It makes no distinction between subsidies to promote food security
and self-reliance, and those meant to increase exports of farm products. As it allows
subsidy only up to 10% of the value of production, it would become almost impossible
for the governments of developing countries to provide price support to particular
agricultural commodities. This is also the case of input subsidies which are allowed only
to low income farmers. Thus all subsidies on such imports as fuel, electricity, fertilisers,
transportations, seeds, etc. to farmers, and consumer subsidy in the form of public
distribution system would have to be abolished. The reduction and removal of subsidies
unaccompanied by a rational price policy would hit farmers in developing countries.
Again, the free market access and the removal of all restrictions on imports would
adversely affect the farming community. Cheap imports of agricultural products would

push farmers out of production. Prices of farm products in international markets are not
determined by competition but by the corprorations of the developed countries which
procure and sell them. Moreover, they would increase foreign debt and worsen the
balance of payments problem. The Agreement lays down the application of sanitary and
phytosanitary measures against the farm products of developing countries. These would
be based on regulations established by such international organisations as the Codex
Alimentarius which is not subjected to any democratic process. This agency might
declare as ―safe‖ products of developed countries and as ―unsafe‖ of developing
countries. These free trade and market-based agricultural systems cannot solve the
problems of developing countries. The persistence of high domestic support to agriculture
in many developed countries has been encouraging over production at high cost to them.
The export subsidies are used to dispose of excess supplies in these countries which
artificially lower the prices of such commodities in the global markets. Further, the
opening up of markets since the WTO Agreement has been in the developing countries
while there has been little success in getting market access in developed countries. For
instance, the share of agricultural exports from developing countries to Western Europe
declined from 30.5% in 1990 to 28% in 1998. Market access to developing countries
continues to be restricted by continuous protection by tariff and other barriers such as
Sanitary and Physiosanitary standards. To safeguard the interest of farmers in developing
countries, certain degree of protection in terms of moderately high tariffs and special
safeguard clause are required to be added in the Agricultural Agreement for sustainable
agricultural development in these countries.
Despite these, the agricultural sector in developing countries is expected to gain much
from this Agreement by generating export surpluses after meeting the growing domestic
demand. They may gain from higher prices of such crops as foodgrains, cotton, etc. and
by diversifying in the areas of horticulture, floriculture, dairy products and other allied
activities with the increase in the tariff bindings to 100% in agricultural products. Further,
the reduction of subsidies to agriculture by the developed countries are expected to make
the exports of developing countries more profitable.
2. Textiles and Clothing. This Agreement would benefit most developing countries
during the transitional period. But the gains to them are likely to be delayed because of

the long period of phasing out of the MFA due to two reasons. First, when a developed
country takes certain types of textiles and clothing out of the MFA, it will apply on a non-
discriminatory MFN (Most-Favoured Nation)basis to all exporting countries. Second,
only 49% of all products would be integrated into the GATT on the last day of the 10-
year transition period. This phasing out period is very long and the WTO may be
pressurised to extend the transition period.
Further, the ―product coverage‖ for the phasing out is so large that all items of textiles
and clothing which are not covered by quotas are included in it. Thus there will be little
phasing out of quota items till the end of the 10-year phasing out period. Recently, the US
has announced a four-stage quota-phaseout programme ending January 2005 under which
90 per cent of the restrictions on Indian apparel exports would actually remain till 2005.
Till then, the Indian apparel exports will suffer. In the EU phaseout programme, one-sixth
of Indian apparel exports would continue to face restriction till 2005.
3. TRIMs. The Agreement on TRIMs is a weak one. Article IV of the Agreement lays
down that developing countries can deviate from the above provisions temporarily. The
extent and manner of deviation would depend upon the interpretation of the contracting
parties. Under this ‗escape‘ clause, the right to regulate foreign companies and trade-
balancing measures have in no way been curtailed if there are valid reasons such as
adverse balance of payments. These safeguards apart, the TRIMs agreement would
remove restrictions on foreign investments. Though foreign direct investment is not
mentioned, yet it is feared that MNCs would try to control high priority areas in
developing countries. Further, the TRIMs mentioned are those that are applied in a
discriminatory manner on foreign owned enterprises when the same requirements are not
applicable to the national enterprises. The Agreement also deals with discriminatory
imports restrictions. On the whole, the TRIMs Agreement has reduced the decision-
making powers of national governments. For instance, they cannot specify local contents
in domestic manufacturing and cannot restrict the percentage of imported inputs in its
exported products or the export of a particular product.
4. GATT Rules. The GATT Rules 1994 pertaining to the phasing out of the quantitative
restrictions (QRs) and preferences are vague. The use of QRs by developing countries to
overcome their balance of payments difficulties has been rendered ineffective by

providing it only for the least developed countries. In the case of developing countries,
QRs would be eliminated and replaced by price-based measures. Only the least
developing countries would impose QRs, but these would be viewed as temporary.
Countries which impose such QRs would publicly announce as soon as possible, time
schedules for their removal. But the developing countries have the right to use different
duty rates for different goods so that they can discourage excessive imports of non-
essential goods. This would enable developing countries to facilitate the import of
essential inputs and capital goods while restricting the import of non-essential goods. One
developing country provides tariff preferences to another under the Global System of
Tariff Preferences (GSTP). Similarly, a developed country offers tariff preferences to a
developing country under the Generalised System of Preferences (GSP). These tariff
reductions are over and above the tariff preferences provided to countries under the Most
Favoured Nation (MFN) obligations of the WTO. As a result, for developing countries in
general, preferential margins will totally disappear in some sectors. The OECD has
estimated that Africa will lose by an average of 30 per cent through the erosion of their
preferences by 2002. Exports of tropical products from the African, Caribbean and
Pacific (ACP) countries will suffer to the extent of 51 per cent. Under the Uruguay
Round Agreement, the developing countries have committed themselves to ―bind‖ their
industrial tariff lines by 72 per cent and 100 per cent for agricultural products. In the
Subsidies Agreement, the developing countries have committed to eliminate subsidies
having an impact on export prices with the result that they will be giving up the policy of
export-led growth. The GATT Rules on anti-dumping leave so much at the discretion of
national governments that very few actions would actually qualify as their violations.
Thus partly due to the GATT Rules and partly due to economic circumstances, anti-
dumping and countervailing duties are being used for restricting trade by the USA, EEC
and other developed countries. Further, the non-technical barriers to trade like the
environmental, health, and sanitary considerations can also act as non-tariff barriers in the
case of developing countries. For instance, the US has tried to block shrimp exports from
India by insisting that they should be caught with devices which do not net turtles.
Obviously, Indian fishermen do not have the means to use such devices.

5. GATS. The GATS goes against the interests of the developing countries. It emphasises
on the liberalisation of only those services such as financial, shipping, transport and
communications, health, educational, professional and media services, in which the
developing countries have a distinct advantage. By liberalising trade in services, the
developed countries aim at seeking control over the production and use of services in
developing countries. The services sector in developing countries would have to face
unequal competition from the vast resources which the firms of developed countries
possess. Many developing countries have a comparative advantage in skilled and
unskilled labour. But their free movement is controlled by stringent immigration laws of
developed countries. But nothing has been proposed on this aspect of the services sector
because the developed countries stand to gain from the selective brain drain of
developing countries. 6. TRIPs. The TRIPs agreement is patently discriminatory. It
would favour the developed countries and go against the interest of developing countries
for the following reasons: It would increase the area of coverage under the patent system
such as drugs, agriculture, plants and animals, etc. As developed countries and their
MNCs have vast resources and facilities for R & D, they would be at an advantage to
invest and patented processes and products. In all such cases, developing countries would
have to pay royalties. The domestic prices of such goods, especially of drugs and
medicines would increase and burden the consumers. There would be larger imports of
patented raw materials and products by developing countries. Exports would receive a
setback. Consequently, there would be worsening of the balance of payments. Even the
developed countries will be affected by TRIPs. According to an estimate, 90 per cent of
the world‘s population would suffer on account of skyrocketing prices of pharmaceutical
products if the TRIPs Agreement is implemented in full. Many developing countries like
India are engaged in R & D programmes in such critical areas as drugs, farm products,
chemical, etc. which would come to a standstill. This is because after the transitional
period of ten years, the patent law would change. The acceptance of TRIPs agreement
would necessitate wide-ranging amendments in the patents laws of developing countries.
A change in the patent laws of developing countries in accordance with the TRIPs
agreement would further lead to brain drain which would prove costly for such countries.
The increase in the patent right to 20 years would again be detrimental to the interests of

developing countries. It is only in the developed countries that patent rights are of 20
years duration. Of course, developing countries would be given 10 years to change their
existing laws. But the TRIPs agreement takes away this concession through the ―classical
pipeline protection‖ clause. According to this clause, patent applications for
pharmaceutical and agricultural products would be accepted by the concerned authorities
even after the agreement came into force from January 1, 1995, irrespective of whether
the national law provided for the grant of product patents or not. For instance, in the case
of a pharmaceutical product normally it takes 10 years from the date of filing a patent to
market it. Consequently, patent protection to such a product would only be necessary
from the year 2005 onwards. When the patent would be valid for only 20 years, nobody
would make investments on new products. Again, the Agreement provides for the grant
of ―exclusive marketing rights‖ in another country to an applicant for a maximum period
of 5 years. The information concerning such innovation would be kept secret even
without the grant of a patent. This provisioin is inimical to the interests of developing
countries because it grants the patentee the right to prevent the use of his patent product
or process being used for the export market. Thus the patented technology might be
provided by an MNC for the exploitation of the local market of a developing country. In
the case of the working of a patent, the patentee would be given the freedom to import the
product instead of setting up the product unit in the other country. The developed
countries and their MNCs would not be under any obligation to transfer their
technologies to the developing countries to satisfy the requirement of ―working‖. Rather,
they would be used as markets for their products. The inclusion of the clause ―reversal of
the burdern of proof‖ is against all canons of justice. It would be for the producers of new
products and processes to prove the non-infringement of their patent rights. It thus
relieves the patentee from producing proof of the infringement of his process or product
patent. This is arbitrary. The TRIPs rules are also self-contradictory. They do not provide
specific mechanism to achieve the objectives of sustainable development and
environmental protection. The link between intellectual property rights and environment
arises because some protected technologies directly
affected the environment in a positive or negative manner. In fact, for technologies
affecting environment, exclusion from patentability or a ban on their use or commercial

exploitation would appear to be prima facie necessary. The TRIPs Agreement does not
clarify whether members can ban the commercial exploitation of environmentally-
injurious technologies while granting patent protection or whether this can give rise to
non-violation type complaints. According to Dr. Deepak Nayyar, the implications of the
TRIPs agreement for the absorption, diffusion and adaptation of technologies, let alone
innovation, in developing countries are far reaching. Much needed technologies may no
longer be available at affordable costs. The emergence of domestic technologies may be
pre-empted. Transfer of technology may slow down. The incidence of restrictive business
practices by MNCs may increase. The implications and consequences of the TRIPs
agreement suggest that the emerging international system for the protection of intellectual
property rights is bound to be inequitable and inimical for the developing countries. 7.
Dispute Settlement. The dispute settlement system of the WTO provides for adjudication
of issues pertaining to the internal policies of the member countries. Such a measure
poses a threat to the sovereignty of countries. For instance, if a request is made to the
WTO for establishing a panel in case of a dispute, the WTO secretariat has been
authorised to propose nominations on the panel. But the parties to the dispute shall not
oppose nominations. In such a situation, the parties to the dispute shall have no say in
decision-making. This tantamounts to interference in their sovereign rights. Moreover,
the powerful developed countries like the US adopt cross-retaliatory measures under the
guise of the dispute settlement mechanism which may go against the developing
countries. Further, there is the US Trade Law Section 301 which allows individual
enterprises to compel the US government to investigate foreign trade practices that
restrict or harm their trade interests. It is doubtful if the WTO dispute settlement system
can resolve complaints arising out of the use of this law. Conclusion. Despite these
criticisms, the formation of the WTO and GATT Rules provide greater transparency,
predictability and security in international trade relations to developing countries.*
WORKING OF WTO
The first Ministerial Meeting of the WTO was held at Suntec City in December 1996 at
Singapore. The ministers of member countries adopted a consensus declaration reaffirming
their faith in the multilateral trading system as the means to promote free world trade. In the
declaration, they renewed their commitment to : (1) a fair, equitable and more open rule-

based system; (2) progressive liberalisation and elimination of tariff and non-tariff barriers to
trade in goods; (3) progressive liberalisation of trade in services; (4) rejection of all forms of
protectionism; (5) elimination of discriminatory treatment in international trade relations; (6)
integration of developing and least developed countries and economies in transition into the
multilateral system; and (7) the maximum possible level of transparency. The Ministers
discussed some new issues of trade such as competition policy, labour standards, multilateral
investment agreement and government procurement. In their declaration, they rejected the
use of labour standards for protectionist purpose, agreed to establish separate working groups
to examine the relationship between trade and investment, to study issues pertaining to the
interaction between trade and competition, including anti-competitive practices, and to
conduct a study on transparency in government procurement practices. They admitted that
progress in negotiations on liberalising world markets in financial services, maritime services
and basic telecommunications had been unsatisfactory which would be completed by the end
of 1997. The only positive side of the Meeting was the launching of the Information
Technology Agreement signed by 28 countries which aims at slashing tariffs on items of
information technology to zero by the year 2000. The first Ministerial Meeting was severely
criticised for the manner in which its decisions were arrived at. There was a facade of
consensus because most developing countries were marginalised in the decision-making
process. The second Ministerial Conference was held at Geneva where the developed nations
made a commitment to reduce subsidies and trade distorting support in agriculture. Provision
was made for special safeguard mechanism for the developing world and the concept of food
security for them was accepted. The Conference also approved the Information Technology
Agreement. The third, Ministerial Conference was held at Seattle (US) in November-
December 1999. The Conference was marred by many controversies between the developed
and developing countries. A large number of member countries emphasised on a new round
of negotiations, called the Millennium Round, covering a wide range of subjects like
investment issues, competition policy, transparency in government procurement, trade
facilitations, trade and labour standards, trade and environment, industrial tariff reduction,
etc. The inclusion of non-trade issues like labour standards in the WTO agenda was
vehemently opposed by the developing countries. The Conference failed due to large
disagreements among the groups of developed and developing countries on certain disputed

issues like textiles, agriculture and anti-dumping. As no concensus based conclusions could
be reached on most of the issues, the Conference failed to kick off a new round of trade talks.
THE DOHA ROUND The fourth round of trade negotiations under the WTO kicked off at
Doha (Qatar) in November 2001. At the Conference, labour standards were removed from
the core agenta of WTO. The main agenda of the Conference was to reduce global trade
bariers covering agriculture, industrial goods and services largely for the benefit of
developing and poor nations. But the Doha Development Round of trade talks slumped into
dead lock with a dead line of 1 January 2005. At the fifth Conference held at Cancun
(Mexico) in September 2003, nothing specific came out of the negotiations. The meet failed
because of disagreement on farm subsidies. This was followed by a July 2004 meeting of
WTO members to identify critical issues of international trade that formed the basis for
negotiations at the next meet at Hongkong in December 2005. At the WTO meet held at
Hongkong in December 2005, 110 developing countries emerged as a powerful group against
US, EU and other developed nations to fight for common interests of both the least
developed and deveoping countries. Consequently, negotiations on the Doha Round
collapsed in July 2006. Since then negotiations have been going on at Geneva to arrive at a
concensus on the latest draft texts on four main issues relating to Agriculture. Non-
agricultureal Market Access (NAMA), Services and Rules. These issues are :
1. Trade in Agriculture. Developed Countries subidise their agriculture more than
developing countries. Farm subsidies are of two types : first, financial subsidies that
support farmers to keep their domestic prices low compared with international prices.
Second, export subsidies to encourage sales of farm produce abroad. Lower prices make
their farm products more attractive in the global markets and make it difficult for
developing countries to compete with them. The developing countries wanted farm
export subsidies to be phased out and domestic subsidies on farm products to be reduced.
But US and EU refused to do so without equivalent access in manufacturing markets in
developing countries. Developing countries like India and Brazil were willing to do so
but not before US and EU cut their subsidies. India, on its part, argued that she had
already cut specific tariffs from 55 per cent to zero. Brazil had to some extent also cut
specific tarifs on cotton, sugar, soyabean, etc. Finally, both EU and US agreed to phase
out all export subsidies by 2013, and phaseout 80 per cent of the subsidies by 2010. To

protect their farmers from a surge of cheap imports from developed countries, developing
countries demanded special permission not to cut import duties on certain products on
which a large number of marginal and small farmers depended. They also sought special
safeguards to raise import duties on select products if their imports surge beyond a certain
level. Regarding the concensus on agriculture, there are still large number of issues on
which there are disagreement while others are within known bounds or sequare brackets,
and are still to be decided. For example, greater market access to the markets of
developed countries for the goods of the developing countries and the issue of non-tariff
barriers to agricultural trade, including phyto-sanitary conditions, and environmental
issues.
2. Non-Agricultural Market Access (NAMA). Under NAMA, both developed and developing
countries were to agree on a formula in order to reduce tariffs on such industrial goods as
auto, consumer electronics, textiles, footwear, etc. The developed countries suggested the
Swiss Formula which required the highest duty cuts in items with the highest tariff. This
favoured the developed countries who viewed the rapidly growing middle class in developing
countries as a profitable market for their industrial products. The developing countries did
not agreee to the Swiss Formula which was modified with lesser duty cuts. Still there was no
concensus and the trade talks were suspended in July 2006.
3. Trade in Services. Trade in services is growing very fast and is the most competitive
globally. WTO provides for four modes for trade in services. The first is cross-border
services negotiations. Developing countries like India have not been able to get a binding
commitment under this. The Hong Kong Declaration talks of only ―guidance‖ and not of any
specific guidelines. The second mode is a plurilateral route to open markets for services. In
this route, a few countries having common interests negtotiate at a multilateral level to open
their services sector. The third mode is the request and the fourth is the offer route. In the
former route, countries make individual requests and in the latter route, they offer the
services of their professionals. The last requires an economic test for the movement of
professionals to other counries. The Hong Kong Declaration eased the need for this test. On
the objection of some developing countries, the plurilateral route clause had been diluted.
The Doha Round after July 2006. After the suspension of Doha Round talks in July 2006, the
Secretariat of WTO prepared three new draft negotiating texts and released them in February

2008. The trade ministers of India, Brazil, US, EU, Japan and Australia met in New Delhi in
April 2008 to review and discuss the latest draft texts on the three main issues holding up the
progress in the Doha Round negotiations. The US accepted WTO proposals on farm subsidy
cuts as a basis for negotiations. Until now, US had refused to accept a ceiling below $23
billion a year, whereas the WTO compromise proposal suggested a limit of $ 12.8 to $16.2
billion a year on its farm subsidies. The main concern of developing nations is on Special
Products and Special Safeguard Mechanism (SSM) for agricultural products. The Special
Products are designed to allow developing countries to impose higher duties on their
vulnerable products that affect the livelihoods of subsistence farmers and the food security of
a nation, while SSM is designed to protect farmers from sudden import surges and price falls
by applying an additional safeguard duty over and above the bound rate. The draft text
proposed to allow member states to raise import duties only if the world prices are lower than
domestic prices by over 30%. A price trigger of 30% was unacceptable to developing
countries who suggested the price trigger at between 5% and 10%. Alongside, there were
parallel proposals for cuts in import tariffs in a range of 19% to 23% on industrial goods by
28 developing counries. But India and Brazil refused to go below 30% in order to protect
their industrial growth. So far as the new draft on NAMA was concerned, it was rejected by
India and other developing countries. The text tried to use divided and rule policy among
developing countries. It proposed a special set of rules for such countries as South Africa,
Venezuela and Mexico that went against India and China. There are two variables around
which the negotiations had been going on. The first is the ―coefficients‖ which mean the
degree to which a country can reduce tariffs. A lower coefficient implies a higher cut in
tariffs. The second is the ―flexibilities‖ which mean the number of products being traded and
the time frame over which the tariff cut will be done. The developing countries headed by
India, sought flexibility to keep Special Products out of the duty cuts because such a
flexibility will benefit them. These are agricultural products guided by indicators based on
the criteria of food securtiy, livelihood security and rural development. By keeping, Special
Products out of tariff reduction would help farmers in developing countries in protecting their
important crops from unfair global competition. The new draft suggested ―sliding scale‖
which envisaged a trade-off not within the flexibilities themselves to protect sensitive sectors
but between the coefficients and flexibilities. This meant that if a country required higher

flexibility to safeguard its sensitive sectors, it would have to resort to a larger tariff reduction.
Another new suggestion was to use the ―average percentage cuts‖ instead of the mandatory
cut in peak tariffs and high tariffs on export products of developing countries. But developing
countries believe that such a proposal would allow the developed countries to have high
tariffs on the exports of the developing countries. Thus the revised draft and suggestions of
WTO are not likely to be accepted by the developing countries because they want tariff peaks
on products of their interest to come down which the developed countries are reluctant to
negotiate at the Doha Round. The new text on services trade required WTO members to
make commitments to maintain current levels of market access and to create new market
access. However, there are minor differences over the trade in services between the
developed and developing countries. The developing countries want increased market
openings for their professionals in developed countries and the rationalisation of Rules text.
Conclusion. So far the Doha Round of trade negotiations have stalled with developing
countries criticising farm subsidies in the developed countries and the developed countries
arguing for lower tariff barriers for their industrial products and services and developing
countries for their agricultural products. The trade talks held in Geneva collapsed on 30 July
2008 after India and other developing countries insisted that there should be enough scope to
protect subsistence farmers and small industries from being submerged by a flood of cheap
imports from the US and the EU.
FOREIGN CAPITAL IN INDIA
INTRODUCTION
India receives foreign capital in the form of : (a) direct foreign investments by MNCs; (b)
indirect investments, known as ‗portfolio‘ or ‗renter‘ investment when foreign
concerns/individuals subscribe to the shares and debentures of Indian companies; (c) foreign
collaborations between private Indian and foreign concerns, between Indian government and
foreign concerns, between Indian and foreign Governments; and lastly, public foreign capital,
known as foreign aid or external assistance, in the form of grants and loans on bilateral basis
from developed countries, and multilateral basis from the Aid India Consortium, IBRD, IMF,
other UN agencies and ADB.
2. GOVERNMENT POLICY TOWARDS FOREIGN CAPITAL

The Government of India‘s policy regarding foreign capital was enunciated in the Industrial
Policy Resolution of April 6, 1948 and in the Prime Minister‘s Statement in the Constituent
Assembly in April, 1949. The latter laid down that ―(a) the participation of foreign capital and
enterprise should be carefully regulated in the national interest by ensuring that major interest in
ownership and effective control should, save in exceptional cases, always be in Indian hands,
that the training of suitable Indian personnel for the purpose of eventually replacing foreign
experts will be insisted upon in all such cases; (b) there will be no discrimination between
foreign and Indian undertakings in the application of general industrial policy; (c) reasonable
facilities will be given for the remittance of profits and repatriation of capital consistent with the
foreign exchange position of the country; and (d) in the event of nationalization, fair and
equitable compensation will be paid.‖ Since then the Government had scrupulously adhered to
this policy statement and had been granting facilities to foreigners to invest and collaborate in
those fields which were considered essential for the country‘s development; those which required
large capital investments and complex production processes; those which helped to produce
import-substituting and export-oriented products; those which undertook to train Indian
entrepreneurs, technicians and labour in the operation of the enterprise; and those which helped
to improve the country‘s foreign exchange resources. It was, however, in the Industrial Policy
Statement of 1973 that a clearcut policy with regard to foreign concerns and subsidiaries and
branches of foreign companies was laid down for the first time. All such companies were made
eligible to participate in the group of 19 industries specified in Appendix 1, but were ordinarily
excluded from other industries. They were to be on the basis of foreign collaboration with Indian
entrepreneurs in the field of equity capital, know-how and technology. The Industrial Policy
Statement of 1977 restricted foreign equity participation to 40 per cent. The participation of
foreign investment and foreign companies was made strictly in accordance with Foreign
Exchange Regulation Act (FERA). It was also laid down that the Government would issue a list
of industries where no foreign collaboration was deemed necessary. The Industrial Policy
Statement of 1980 laid the following guidelines regarding foreign collaboration and technology.
In order to promote technological self-reliance, the Government recognised the necessity of
continued inflow of technology in sophisticated and high priority areas. In areas, where Indian
skills and technology were not adequately developed, the Government would prefer outright
purchase of the best available technology so as to adapt it to the needs of the country. Indian

firms which were permitted to import foreign technology were required to set up adequate R & D
facilities so that imported technology was properly adapted and assimilated within the country.
Regarding participation of foreign investment and foreign companies in India‘s industrial
development, the Government made it clear that the provisions of the FERA would be strictly
enforced on the existing foreign countries. But a higher percentage of foreign equity was
considered in priority industries if the technology was sophisticated and not available in the
country, or if the venture was largely export-oriented. For all approved foreign investment,
financial and/or technological, there was complete freedom for remittance of profits, royalties,
dividends, as well as repatriation of capital, subject to rules and regulations common to all. As a
rule, majority interest in ownership and effective control was in Indian hands. There were,
however, exceptions in highly export-oriented and/or sophisticated technology areas. In hundred
per cent export-oriented areas, even a fully owned foreign company was allowed. In the
Industrial Policy Statement of 1991, the Government announced a more liberalised foreign
investment policy. Its main features with modifications in subsequent years had been : (i) as
against the past policy of considering all foreign investment on a case-by-case basis within the
ceiling of 40 per cent of total equity investment, the new policy provides automatic approval of
direct foreign investment up to 51 per cent of foreign equity holding; (ii) automatic approval is
given for foreign direct investment in 34 high priority, capital-intensive, hi-technology
industries—provided the foreign equity covers foreign exchange involved in importing capital
goods, and outflows on account of dividend payments are balanced by earnings over a period of
7 years from the commencement of production; (iii) technology imports for such industries are
automatically approved for royalty payments upto 5 per cent of domestic sales and 8 per cent of
export sales or lumpsum payments of Rs. 1 crore; (iv) foreign technology agreements are also
liberalised for the 34 industries with firms left free to negotiate the terms of technology transfer
based on their own commercial judgement and without the need for prior Government approval
for hiring of foreign technicians and foreign testing of indigenously developed technologies; (v)
in order to avail of professional marketing activities for systematic exploration of world markets
for foreign products, foreign equity holding upto 51 per cent are permitted for trading companies
as well; (vi) the procedures for investment in non-priority industries have been streamlined. A
special Board, called the Foreign Investment Promotion Board (FIPB), has been established to
negotiate with large international firms and to expedite the clearances required. The FIPB also

considers individual cases involving foreign equity participation of more than 51 per cent; (vii)
existing foreign companies are allowed to raise their equity to 51 per cent without approval;
(viii) NRIs and overseas corporate bodies predominantly owned by them are permitted to invest
up to 100 per cent equity in high priority industries with freedom to rapatriate their capital and
income. NRI investment up to 100 per cent is also allowed in export houses, trading houses, star
trading houses, EOUs, hospitals, sick industries, hotels and tourism related industries, houses and
infrastructure; (ix) disinvestment of equity by foreign companies is allowed at market rates on
stock exchanges with permission to repatriate the proceeds of such disinvestments; (x) FDI is
allowed in the priority areas like power, oil refining, marketing of gas, electronics and electronic
equipments, chemicals, food processing, telecommunication, industrial machinery, etc.; (xi)
provisions of FERA have been liberalised whereby companies with more than 40 per cent of
foreign equity are also treated on par with Indian owned companies; (xii) India has signed the
MIGA Protocol for the protection of foreign investment; (xiii) foreign companies have been
allowed to use their trade marks in Indian market; (xiv) FIIs are allowed to invest in Indian
capital markets up to 30 per cent of the paid-up capital of a company after registration with
SEBI; (xv) investment norms for NRIs have been liberalised so that NRIs and overseas bodies
can buy shares and debentures of Indian companies; and (xvi) Indian companies have been
permitted to operate in international capital markets through Euro-equity shares. Since May
2001, the Government has opened up the following new sectors to foreign investment : (a) 26 per
cent foreign equity allowed in defence production which has been opened 100 per cent to private
Indian companies; (b) FDI limit raised to 49 per cent in the banking sector; (c) drug and
pharmaceutical sector, airports, township development, hotels and tourism, courier service and
mass rapid transport system opened to 100 per cent FDI; (d) FDI up to 74 per cent permitted for
internet service providers with gateways, radio paging, end-to-end hand-width in the telecom
sector, and FDI up to 26 per cent in the insurance sector; and (e) NRI investors allowed to
repatriate foreign exchange.
3. FOREIGN CAPITAL IN INDIA

India has been receiving foreign capital in the form of direct and portfolio foreign investment,
external commercial borrowing (ECBs), NRI deposits and external assistance. We discuss them
as under.

EXTERNAL ASSISTANCE India has been receiving foreign aid in the form of loans, grants
and under the United States Public Law 480/665, etc., repayable in convertible currency and
rupees. The gross and net aid received in different Plan periods is indicated in Table 1. The table
shows that net aid as a percentage of Plan expenditure rose from 9.1 per cent in the First Plan to
28.1 per cent in the Second Plan, to 27.2 per cent in the Third Plan, to 33.9 per cent in the three
Annual Plans and thereafter it started declining to 11.2 per cent in the Fourth Plan, to 9.1 per cent
in the Fifth Plan, to 5.5 per cent in the Sixth Plan, and 4.6 per cent in Seventh Plan. It was 5 per
cent in the Eighth Plan, 4.3 per cent in the Ninth Plan and 2.9 per cent in the Tenth Plan. Table 1
shows authorisation and utilisation of external assistance. The overall external assistance
authorised to India from April 1951 to March 1997 was of the order of Rs. 3,59,380 crores. Of
this, Rs. 2,69,170 crores had been utilised, which shows a utilisation rate of 75 per cent. This
means that the absorptive capacity of the economy is not quite high. But over the years the
utilisation rate has not been uniform. Rather, it has been fluctuating, sometimes reaching hundred
per cent as during the Fourth Plan and at other times even exceeding hundred per cent as during
the Third Plan (102%), and the Fourth Plan (100.3%)*, as revealed by Table 1. But during the
first two Plans the rates of aid utilisation were 55 and 56 per cent respectively. This was due to
project aid by the donor countries and time consuming formalities of preproject surveys in India,
delays imposed by the industrial and import licensing procedures of the Government,
Government, and lack of coordination in various government agencies. After the
recommendations of the V.K.R.V. Rao Committee on Utilisation of External Assistance in 1964,
the procedures for utilisation have been streamlined. Consequently, the rate of utilisation had
been quite high, except for the Seventh Plan when it slumped to 50 per cent. This has been
primarily due to the delay in authorisation on the part of the consortium countries.

Of the total aid utilised by India, loans are the main components. For instance, in 2006-07 loans
accounted for 89 per cent and grants 11 per cent of the total aid utilised. Of the loans, 30 per cent
are in the form of untied credits and the remaining are tied credits. Since the bulk of the loans are
tied, they tend to push up the cost of the projects by more than 30 per cent to India because the
country is required to pay more than the competitive world market prices to the creditor country.
It increases further when, as in the case of US supplies, India is forced to get machinery, spare
parts, raw materials, etc. in American ships. This not only tends to reduce the real value of aid to
the country but also distorts the allocation of resources within the country.
EXTERNAL COMMERCIAL BORROWINGS

(ECB) ECBs include loans from commercial banks and other financial institutions, bonds and
borrowings from International Finance Corporation, ADB, etc. by Indian public sector, private
sector, financial institutions, etc. They provide an additional source of funds for Indian
companies for financing the expansion of existing capacity and new investment and to take
advantage of the lower interest rates in international markets. India‘s reliance on ECBs has been
on the increase since the 1980s. Gross borrowings rose from $ 10.2 billion in March 1991 to $
41.7 billion in March 2007.
NRI DEPOSITS Non-resident Indian deposits are a major source of capital inflows into India.
Indian nationals and persons of Indian origin resident abroad can open bank accounts in India
freely out of funds remitted from abroad or foreign exchange brought in India or out of funds
legitimately due to them in India. Total outstanding balances under all NR deposits schemes
increased from $ 4.6 billion in March 1986 to $ 10.2 billion in March 1991. But declined to $ 7.8
billion in March 1992, due to the Gulf War. These flows gained momentum as a result of
relaxations of reserve requirements and rationalisation of interest rates on deposits in subsequent
years. As a result, they increased to $41.2 billion in March 2007.
FOREIGN INVESTMENT
Foreign investment comes to India in the form of foreign direct investment (FDI) and portfolio
investment. Prior to the beginning of liberalisation, the inflows were very small, being $ 113
million in 1990-91. Of these, $ 107 million was FDI and $ 6 million was portfolio investment.
With liberalisation, portfolio investment comprising Foreign Institutional Investors (FIIs) and
investment under ADRI, GDR route, and FDI had increased to $ 29.2 billion in 2006-07. Of this,
portfolio investment in 2006-07 was $ 7.1 billion and FDI $ 22.1 billion.
INDIA’S EXTERNAL DEBT India‘s external debt consists of bilateral and multilateral
government and non-government external assistance, external commercial borrowings (ECBs)
and IMF liabilities, and outstanding NRI deposits. The volume of India‘s external debt started
growing rapidly during 1980s. From about US $ 8 billion in 1970, it grew to $ 21 billion in 1980,
to $ 76 billion in 1990 and to $ 169.6 billion at the end of March 2007. Over the years, the
composition of debt stock has undergone a notable change. In 1980, the external debt stock
consisted mainly of external assistance which constituted 90 per cent of the debt stock. Since
then, the share of external assistance had been on the decline and that of ECBs on the increase.
The share of external assistance fell to 60 per cent in 1990 and to 21 per cent in 2007. On the

other hand, the share of ECBs increased from 12 per cent in 1990 to 25 per cent in 2007. Net
NRI deposits as the ratio of total capital flows fell from 18.3% in 1990-91 to 9.3% in 2006-07.
While net FDI as percentage of GDP increased from zero in 1990-91 to 0.9% and portifolio
investment from zero to 0.8% over the period. But external debt to GDP ratio which measures
the size of debt in relation to the domestic output improved from 28.7 per cent in 1991 to 17.9
per cent in 2007. Another feature of India‘s external debt is the high share of concessional debt
in the total debt. This remained fairly stable on an average at 45 per cent during 1990-96. But
had been on the decline since then being 38.5 per cent in 2000 and 23.3 per cent in 2007. This
continues to be high by international standards. According to World Bank's Global Development
Finance, 2006, India‘s share of the concessional debt was the highest among the top 10 debt
countries of the world in 2006. No doubt, India‘s external debt position has improved in recent
years, but it is still alarming. In 2006 India ranked as the fifth largest debtor country after Brazil.
MEASURES TO REDUCE EXTERNAL DEBT
The stock of external debt in India should be such that debt service payments are within
reasonable limits. But there is no way to determine what the debt service ratio should be.
However, the general view is that the debt service ratio should not normally exceed 30 per cent.
The country should try to keep this ratio below this level by increasing the export growth of
goods and services at a faster rate. With the decline in ODA, India will have to depend more on
inflows of private foreign capital, especially FDI. The country should take more positive
measures to attract such investment in infrastructure sectors which suffer from serious shortages
of finance, technologies and management skills. During 1995-97 some measures have been
adopted to attract FDI in infrastructure but they are not enough. ―Unfortunately, although in
terms of approvals a large amount is proposed for the infrastructure sector, a substantial part of
the investment is flowing into the consumer goods industry. The investments in infrastructure
sector have not made much progress largely on account of (a) slow progress in creating
appropriate institutional framework; and (b) the many existing bureaucratic problems at the same
level. The comparative slow progress in the area also reflects the still ―wait and watch‖ policy to
the large investors regarding the progress of many of the unfinished tasks under India‘s reform
programme, guarantee or confidence on a proper rate of returns and other socio-political
issues‖.2 Therefore, India will have to further improve its economic management by reforming
the institutional structure and through greater transparency in its regulatory framework. So far as

the portfolio investment is concerned, FIIs are undoubtedly the largest contributors of private
foreign investment inflows. But portfolio investment is pro-cyclical in nature i.e. it flows in
when the economy is progressing and flows out when it is in recession. Thus portfolio
investment requires proper phasing and consant monitoring of flows. If FIIs go to the primary
market, its volatility may become less. But most FIIs in India invest in the secondary market.
Thus steps should be taken to encourage FIIs to invest more in the primary market and at the
same time their investment in the secondary market should be regulated in order fo fix the
composition of their inflows. Moreover, greater incentives should be provided to NRIs to open
more non-repatriable deposits. For the increase in the non-repatriable deposits tends to reduce the
external debt. Keeping in view the fact that India‘s external debt has a large component of short-
term debt, India‘s debt service payments will increase further which will make its debt position
more alarming. With the shrinking of ODA, the country will need higher foreign exchange
reserves than its historical level of three months import. Therefore, ―What is urgently needed is
high growth of exports, more inflows of non-interest bearing debt, NRI deposits, a growing
economy with reduced interest rates and last but not the least, reduced fiscal deficit of the
Government‖. By adopting the measures outlined above, it may be possible to bring down the
external debt stock and the debt service ratio.
IMPACT OF FOREIGN CAPITAL ON INDIA’S ECONOMIC DEVELOPMENT Foreign
capital and technology have been playing a useful role in India‘s economic development. At the
time of Independence, India inherited an industrial structure restricted to a few industries like
textiles and sugar. There were only two steel plants and some limited development of
engineering in railway workshops and assembly plants. Today, the industrial structure has been
widely diversified covering broadly the entire range of consumer, intermediate and capital goods.
In most of the manufactured products, the country has achieved a large measure of self-
sufficiency with foreign collaboration but primarily through domestic efforts. This is indicated
by the decline in relative share in industrial production of the traditional manufacturing sectors
like food and textiles and the substantial increase in the production of new sectors like
engineering and chemicals. The diversification of industrial structure is further reflected in the
commodity composition of our foreign trade in which the share of imports of manufactured
products has steadily declined and that of engineering products has become a growing
component of exports. The rapid stride in industrialisation has been accompanied by

corresponding growth in technological and managerial skills obtained from abroad, not only for
efficient operation of highly complex and sophisticated industrial enterprises but also for their
planning, design and construction.
Foreign capital has also been instrumental in filling the gap between domestic saving and the
capital needed for development. This is revealed by the net aid as percentage of Plan expenditure
in Table 1. During the Second Plan, the Third Plan and the Three Annual Plans, its contribution
had been very substantial, being 28 per cent, 27 per cent and 34 per cent respectively. Further,
foreign capital has helped the country in supplying the much needed foreign exchange thereby
filling the foreign exchange gap to a considerable extent. The foreign exchange gap equals the
difference between imports and exports which can be filled by net capital inflow, and build-up of
foreign exchange reserves comprising foreign currency assets, gold, SDRs and Reserve Tranche
position in the IMF. Foreign exchange reserves of India had been rising and declining from
1950-51 to 1990-91. But after that they have been on the increase. They increased from $9.2
billion in 1991-92 to $ 199.2 billion in 2006-07. Foreign capital has been a major factor in
India‘s drive towards self- reliance and import substitution in critical areas. Import substitution
has led to diversification of domestic production and consequent reduction in imports for certain
critical areas like machinery manufacture, crude oil and petroleum products, infrastructural
development, etc. Even in such areas as project consultancy, design engineering and project
implementation, the country has been able to export these services. This has been made possible
through the development of indigenous expertise with the help of foreign assistance. Besides,
foreign capital has helped in boosting our exports by modernising and diversifying India‘s
industrial structure. In fact, India has been receiving foreign technical assistance in two broad
categories of services : (a) engineering-related such as feasibility studies, designing, and
construction supervision; and (b) institutional improvements, project-related training and
management and policy studies. This has helped in upgrading Indian expertise and personnel to
international levels. Foreign aid has increased India‘s ability to cope with shortfalls in food
production and raw materials for consumer goods industries. India has been importing
substantial quantities of foodgrains, oils and new materials at concessional terms during
recurring droughts. Help by international organisations in the field of agricultural research has
led to the development of new agricultural technologies in tools, implements, seeds, irrigation,
cropping pattern, better farm practices, etc. This has resulted in manifold increase in food

production. Thus it is on the basis of food imports and increased food production within the
country, that the Government has been able to build buffer stocks and stabilise food prices.
Besides, foreign aid from international organisation like the World Bank and IDA has helped
India in expanding and modernising its irrigation and power potential, development in rail, road
and sea transport, communications, etc. Above all, foreign aid has been assisting the Government
in the development of its integrated health and family welfare programmes throughout the
country.
4.4 GLOBALISATION
Introduction
Globalisation is a more advanced form of internationalisation of business that implies a degree of
functional integration between internationally dispersed economic activities. It denotes the
increased freedom and capacity of individuals and firms to undertake economic transactions with
residents of other countries.
Globalisation is the process of international integration arising from the interchange of world
views, products, ideas, and other aspects of culture. Globalisation refers to processes that
promote world-wide exchanges of national and cultural resources. Advancement in
transportation and telecommunications infrastructure, including the rise of the internet, has
further catalysed globalisation of economic activities. Several basic activities like investment
(particularly foreign direct investment), the spread of technology, strong institutions, sound
macroeconomic policies, an educated workforce, and the existence of a market economy leads to
greater prosperity. There is substantial evidence, from countries of different sizes and different
regions, that as countries "globalise" their citizens‘ benefit, in the form of access to a wider
variety of goods and services, lower prices, more and better-paying jobs, improved health, and
higher overall living standards. It is probably no mere coincidence that over the past 20 years, as
a number of countries has become more open to global economic forces, the percentage of the
developing world living in extreme poverty which is defined as living on less than $1 per day,
has been cut in half.
Meaning of Globalisation

Economic "globalisation" is a historical process, the result of human innovation and
technological progress. It refers to the increasing integration of economies around the world,
particularly through the movement of goods, services, and capital across borders. The term
sometimes also refers to the movement of people (labour) and knowledge (technology) across
international borders. There are also broader cultural, political, and environmental dimensions of
globalisation.
The term "globalisation" began to be used more commonly in the 1980s, reflecting technological
advances that made it easier and quicker to complete international transactions – both trade and
financial flows. It refers to an extension beyond national borders of the same market forces that
have operated for centuries at all levels of human economic activity – village markets, urban
industries, or financial centres.
According to International Monetary Fund (IMF), globalisation means ―the growing economic
interdependence of countries world wide through increasing volume and variety of cross-border
transactions in goods and services and of international capital flows and also through the more
rapid and widespread diffusion of technology‖.
Globalisation refers to the process of increasing economic integration and growing economic
interdependence between nations. It means integration of different economies of the world into
one global economy thereby reducing the economic gap between different countries. This is
achieved by removing all restrictions on the movement of goods, services, capital, labour and
technology by removing all restrictions on the movement of goods, services, capital, labour and
technology between nations. Globalisation leads to an increased level of interaction and
interdependence among different countries. There is free flow of goods, services, technology,
management practices and culture across national boundaries. From a country‘s view point,
globalisation means integration of the domestic economy of a country with the world economy.
In brief, globalisation implies being able to manufacture in the most cost-effective way possible
anywhere in the world, being able to procure raw materials and management resources from the
cheapest source anywhere in the world, and having the entire world as one market. The global
corporations of today conduct their operations worldwide as if the entire world were a single
entity. Globalisation also implies emergence of a world where innovation can arise anywhere in
the world. Perhaps more importantly, globalisation implies that information and knowledge get
dispersed and shared.

Innovators in business or government can draw on ideas that have been successfully
implemented in one jurisdiction and tailor them to suit their own jurisdiction. Joseph Stiglitz, a
Nobel laureate and frequent critic of globalisation, has nonetheless observed that globalisation
"has reduced the sense of isolation felt in much of the developing world and has given many
people in the developing world access to knowledge well beyond the reach of even the wealthiest
in any country a century ago‖.
BENEFITS OF GLOBALISATION
1. Increase in Competitive Strength of domestic industry: Globalisation exposes domestic
industry in developing countries to foreign competition. This put domestic companies under
pressure to improve efficiency and quality and reduce costs. Under a protective regime industry
lose the urge to improve efficiency and quality. Globalisation helps to improve the competitive
strength and economic growth of developing nations.
2. Access to Advanced Technology: For a developing country like India, globalisation provides
access to new technology; Indian companies can acquire sophisticated technology through
outright purchase or through joint ventures and other arrangements.
3. Access to Foreign Investment: Globalisation has attracted the much needed foreign capital
towards developing countries like India. Foreign multinationals have invested billion of dollars
in India. In addition, foreign institutional investors have brought in huge funds in stock markets
in India.
4. Reduction in Cost of Production: In a globalised environment, companies can secure cheaper
sources of raw materials and labour. For example, several foreign companies have set up BPOs
and call centres in India due to lower cost of labour. Sometimes, a company may carry out its
entire manufacturing in a foreign country to minimize cost of production.
5. Growth and Expansion: When the domestic market is not large enough to absorb the entire
production, domestic companies can expand and grow by entering foreign markets. Japanese
firms flooded the US markets with automobiles and electronics because of this reason.
Companies from USA, Europe and other developed regions are increasing their presence in Asia
due to growing population and increasing income levels in Asian countries.
6. Higher Volume of Trade: Due to globalisation, each country can specialize in the production
of goods and services in which it has a comparative advantage. It can export its surplus output

and import their items freely from other nations. This will lead not only to a phenomenal
increase in the world trade but also to better allocation and utilization of resources in each
country.
7. Consumer Welfare: Better quality and low priced goods and services will become available to
consumers. This along with a wider choice in consumption will help improve standards of living
of people in developing countries. Over a period of time, the proportion of people below the
poverty line will go down. Consumers also get access to products manufactured in any part of
the world.
8. Other benefits: Globalisation also offers some spin off benefits. It helps in the
professionalization of management. Globalisation brings people of different races and ethnic
backgrounds closer. It helps to promote mutual cooperation and world peace.
CRITICISMS OF GLOBALISATION
1. Threat to Domestic Industry: Globalisation leads to increasing role of foreign companies in the
domestic economy of a country. This is likely to hamper the growth of domestic companies.
Small and medium firms in a developing country like India are not in a position to compete with
giant firms of developed nations.
2. Unemployment: Globalisation brings about rapid technological changes. Advanced
technology might create unemployment problems, particularly in developing country.
3. Threat to Democracy: Globalisation requires very fast movement of capital and labour across
national frontiers. These increase the pressure for conceptual and structural readjustments to the
breaking point. The social and human costs of globalisation may put the social fabric of a
democracy in danger.
4. Economic Instability: Globalisation leads to a tremendous redistribution of economic power.
Such redistribution will translate into a redistribution of political power. The change is likely to
have a destabilizing effect.
5. Disregard of National Interest: A developing economy might become excessively dependent
on global corporations. This may not be in the national interest.
4.5 Global Financial Crisis of 2008-2009
The Global Financial Crisis of 2008-2009 refers to the massive financial crisis the world faced
from 2008 to 2009. As the facts stand, the global recession was caused by the collapse of the
housing boom in the US. The collapse of the hosing boom was caused by supply of houses in

excess of demand. The excess supply of houses was the result of over-investment in the housing
sector. The supply of housing in excess of demand caused a 50% decline in the housing prices.
This caused tremendous financial loss to the sub-prime house mortgagers. Therefore, they could
not pay their debt to the banks and financers.
This is what caused the sub-prime crisis. Due to the sub-prime crisis, the banks suffered
unprecedented losses. As a result, banks turned bankrupt and pulled down their shutters. The
result was a big financial crisis in the US, leading to fall in investment and downturn in the US
economy. The US financial crisis affected the financial sector of all the related economies, on the
one hand, and decline in consumer demand resulted in fall in imports, on the other, which
affected exports of the exporting countries. This was the basic cause of the global recession..
The Aftermath of the Global Financial Crisis of 2008-2009
Many who took out subprime mortgages eventually defaulted. When they could not pay,
financial institutions took major hits. The government, however, stepped in to bail out banks.
The housing market was deeply impacted by the crisis. Evictions and foreclosures began within
months. The stock market, in response, began to plummet and major businesses worldwide
began to fail, losing millions. This, of course, resulted in widespread layoffs and extended
periods of unemployment worldwide. Declining credit availability and failing confidence in
financial stability led to fewer and more cautious investments, and international trade slowed to a
crawl.
Eventually, the United States responded to the crisis by passing the American Recovery and
Reinvestment Act of 2009, which used an expansionary monetary policy, facilitated bank
bailouts and mergers, and worked towards stimulating economic growth.
Impacts of the US Financial Crisis on India
Looking at India‘s problems, India‘s financial markets – equity markets, money markets, forex
markets and credit markets – had come under pressure due to (i) global liquidity squeeze,
reversal of capital flows causing forex problem.22 Besides, due to global slump in demand,
India‘s exports had declined by 33.3% in March and by 33.2 in April 2009 compared to exports
in the respective months in 2008. This was worst performance of India‘s export sector in the last
14 years.
Imports had declined by 36.6%. in April 2009 compared to exports in April 2008. According to
the RBI projections, the economic slowdown in India might continue till 2010, in spite of

intensive use of monetary policy measures, reason being the low business confidence, decline in
consumer spending and rise in unemployment rate. However, the Indian economy showed its
strong resilience against the effects of global recession. According to an official estimate, Indian
economy registered a growth of 6.7% in 2008-09, the year of the global recession, which was
substantially higher than 5-6% projected by the individual economists and analysts.
CASE STUDY
To understand stories about how trade works, it is useful to know some of the key facts abo
trade. A good start is a broad overview of the products traded and trade‘s growing importance.
How large is international trade? What products are traded? The table below shows exports by
major product categories, for the world overall and for two broad economic groups of countries,
the industrialized (or developed or advanced) countries and the developing countries.
In 2012, world trade was nearly $23 trillion, with the industrialized countries contributing a little
over half of world exports. Most goods are traded across national borders, as are many services,
including transportation, computer and information services, as well as insurance, consulting,
and educational services. For the world, about half of trade is in manufactured products, with the
rest of trade split between primary products and services. By comparing the details across the
columns, we can see that the broad pattern of exporting by the industrialized countries has some
differences from the pattern for developing countries. Industrialized countries export relatively
less of primary products, especially fuels. In manufactured products, industrialized countries
export relatively more of chemicals, while developing countries export relatively more of textiles
and clothing. Industrialized countries are relatively strong in exporting services. We will use this
kind of observation—looking at trade across product categories—as we examine why countries
trade with each other.
How important is international trade in the economies of various countries? The second table in
this box examines one measure of the importance of trade to a country, the ratio of the sum of a
country‘s total trade (exports plus imports) to the country‘s gross domestic product (GDP, a
standard way of measuring the size of a country‘s economy). These measures are not completely
comparable (exports and imports measure full sales values, while GDP measures value added).

Still, they provide a reasonable way of comparing the importance of trade across time and across
countries.
Here are a few observations about what we see in this table. First, for each of the countries
shown in the table (and for most other countries), international trade has become more important.
Trade‘s increasing importance is one part of the process of globalization—in whichrising
international transactions increasingly link together what had been relatively separate national
economies. Second, trade tends to be more important for countries with smaller economies (such
as Canada and Denmark) and somewhat less important for very large economies (such as the
United States and Japan). Third, both China and India have gone from being mostly closed to
trade to much more open and involved.
DISCUSSION QUESTION
Given the trends shown here, do you think that international trade should have become more
controversial or less controversial than it was several decades ago?

CASE STUDY
Mercantilism was the philosophy that guided European thinking about international trade in the
several centuries before Adam Smith published his Wealth of Nation s in 1776. Mercantilists
viewed international trade as a source of major benefits to a nation. Merchants engaged in trade,
especially those selling exports, were good— hence the name mercantilism . But mercantilists
also maintained that government regulation of trade was necessary to provide the largest national
benefits. Trade merchants would serve their own interests and not the national interest, in the
absence of government guidance.
A central belief of mercantilism was that national well-being or wealth was based on national
holdings of gold and silver (specie or bullion). Given this view of national wealth, exports were
viewed as good and imports (except for raw materials not produced at home) were seen as bad. If
a country sells (exports) more to foreign buyers than the foreigners sell to the country (the
country‘s imports), then the foreigners have to pay for the excess of their purchases by shipping
gold and silver to the country. The gain in gold and silver increases the country‘s well-being,
according to the mercantilist belief. Imports are undesirable because they reduce the country‘s
ability to accumulate these precious metals. Imports were also feared because they might not be
available to the country in time of war.
In addition, gold and silver accruing to the national rulers could be especially valuable in helping
to maintain a large military for the country. Based on mercantilist thinking, governments (1)
imposed an array of taxes and prohibitions designed to limit imports and (2) subsidized and
encouraged exports.
Because of its peculiar emphasis on gold and silver, mercantilism viewed trade as a zerosum
activity—one country‘s gains come at the expense of some other countries, since a surplus in
international trade for one country must be a deficit for some other(s). The focus on promoting
exports and limiting imports also provided major benefits for domestic producer interests (in
both exporting and import-competing industries).
Adam Smith and economists after him pointed out that the mercantilists‘ push for more exports
and fewer imports turns social priorities upside down. Here are the key points that refute
mercantilist thinking:

• National well-being is based on the ability to consume products (and other ―goods‖ such as
leisure and a clean environment) now and in the future. Imports are part of the expanding
national consumption that a nation seeks, not an evil to be suppressed.
• The importance of national production and exports is only indirect: They provide the income to
buy products to consume. Exports are not desirable on their own; rather, exports are useful
because they pay for imports.
• Trade freely transacted between countries generally leads to gains for all countries—trade is a
positive-sum activity.
In addition, even the goal of acquiring gold and silver can be self-defeating if this acquisition
expands the domestic money supply and leads to domestic inflation of product prices—an
argument first expounded by David Hume even before Smith did his writing.
Although the propositions of the mercantilists have been refuted, and countries no longer focus
on piling up gold and silver, mercantilist thinking is very much alive today. It now has a sharp
focus on employment. Neo-mercantilists believe that exports are good because they create jobs
in the country. Imports are bad because they take jobs from the country and give them to
foreigners. Neomercantilists continue to depict trade as a zero-sum activity. There is no
recognition that trade can bring gains to all countries (including mutual gains in employment as
prosperity rises throughout the world). Mercantilist thinking, though misguided, still pervades
discussions of international trade in countries all over the world.
DISCUSSION QUESTION
Proponents of national competitiveness focus on whether our country is winning the battle for
global market share in an industry. Is this a kind of mercantilist thinking? Why or why not?
CASE STUDY
If free trade is so good, why do so many people fear it? Activists and protesters have recently
been complaining loudly that trade has bad effects on

• Workers in developing countries.
• Workers in the industrialized countries.
• The natural environment.
Analysis of absolute advantage and comparative advantage focuses on a resource called labor, so
let‘s focus on trade and workers. (Most of our examination of issues related to the natural
environment)
Can the classical analysis pioneered by Smith and Ricardo really tell us anything about current
controversies? The most interesting case is the one presented in the text, in which one country
(now call it the North) has an absolute advantagein the production of all products, and the other
country (now call it the South) has an absolute disadvantage. Three prominent questions can be
examined within this framework:
1. If labor in the North is so productive, will workers in the South be overwhelmed so that free
trade makes the South poorer?
2. If wages in the South are so low, will workers in the North be overwhelmed so that free trade
makes the North poorer?
3. Does trade lead to harm to and exploitation of workers in the South, as indicated by the low
wages (and/or poor working conditions)?
The text has already answered the first question.
The South will have a comparative advantage in some set of products, and production of these
products will thrive in that country.
The opening of trade will lead to reductions of jobs producing the products that are imported
from the North, but these workers can shift to the expanding export-oriented industries. While
there may be some transition costs borne by the workers who must shift from one industry to
another, the South still gets the gains from trade—generally, it becomes richer, not poorer How
is it that some products produced by (absolutely) low-productivity workers in the South can
compete successfully? The answer must be that workers in the South have low wages.

The cost of producing a unit of a product is the ratio between the wage rate paid to a worker and
the productivity of the worker. Production cost can be low if wages are low, or if productivity is
high, and what really matters is the relationship between the two.
For the South‘s comparative-advantage products (the ones for which the productivity
disadvantage is smallest), the lower wages lead to low production costs and the ability to export
successfully.
For the comparative-disadvantage products, the large productivity disadvantage is not offset by
the lower wages, and these products are imported from the North.
But if wages in the South are low, how can products produced by high-wage workers in the
North compete? The answer to this second question is the other side of the answer to the first.
The North has comparative advantage in a set of products because in these products its (absolute)
productivity advantage is the largest. Even with high wages, the cost of producing these products
is low because the workers are highly productive.
The North can successfully export these products because high productivity leads to low
production costs. By using its comparative advantage (maximizing its absolute productivity
advantage), the North gets the gains from trade—generally it also becomes richer, not poorer.
But is this fair? Why should the workers in the North have high wages and the workers in the
South have low wages? Does this show that the workers in the South are being exploited by
trade? A big part of the answer to these questions is that absolute advantage does matter. But it
matters not for determining the trade pattern but rather for determining national wage levels and
national living standards. Workers can receive high wages and enjoy high living standards if they
are highly productive. Workers with low productivity are paid low wages. (See the
accompanying figure for recent evidence for a number of countries that shows how true this is.)
The low wages in the South are the result of the low labor productivity, and wages in the South
are going to be low with or without trade. Trade does not exploit these workers. In fact, because
of the gains from trade, workers in the South can earn somewhat higher wages and have
somewhat better living standards. Still, as long as productivity remains low in the South, workers
in the South will remain relatively poor, even with free trade.

Is there anything we can do if we still think that it is unfair that workers in the South earn such
low wages? Trade by itself is not the solution (though it also is not the culprit). Some kind of
government mandate to pay higher wages in the South is also not the solution. Forcing higher
wages would raise production costs, and this would just shrink some of the export-oriented
industries that have productivity levels not much below the productivity levels in the North.
The true solution must be to find ways to increase the productivity of workers in the South.
While Ricardo‘s approach does not indicate what determines labor productivity, we know some
changes that would be desirable: increasing worker quality by enhancing education and health,
upgrading production technologies and management practices, and reforming or liberalizing
restrictive and distortionary government policies. In short, absolute advantage matters—to raise
wages and living standards, we need to raise productivity.

CASE STUDY
What if trade doesn‘t balance?
You may be struck by a contradiction between the spirit of the trade theory and recent headlines
about international trade.
The theory assumes that trade balances. The theory assumes equality between the market value
of a country‘s exports and the market value of its imports (both values calculated using the
international price ratio). The balance seems guaranteed by the absence of money in the
discussion.

As long as countries are just bartering wheat for cloth, they must think U.S. wheat exports have
exactly the same market value as U.S. cloth imports. Trade must balance.
Yet the news media have been announcing huge U.S. trade deficits every year since 1975.
Imports of goods and services keep exceeding exports. (Conversely, Japan, Germany, and France
have been running trade surpluses in most years since that time.) What‘s going on? How can the
basic theory of trade be so silent about the most newsworthy aspect of international trade flows?
Isn‘t the theory wrong in its statements about the reasons for trade or the gains from trade?
Maybe Ricardo was too optimistic about every country‘s having enough comparative advantage
to balance its overall trade.
These are valid questions, and they deserve a better answer than simply ―Well, the model
assumes balanced trade.‖ We will discuss about how trade deficits and surpluses relate to
exchange rates, money, and finance. But the real answer is more fundamental:
The model is not really wrong in assuming balanced trade, even for a country that currently has a
huge trade deficit or trade surplus!
Take the case of the U.S. trade deficit. It looks as though exports are always less than imports.
Well, yes and no. Yes, the trade balance (more precisely the ―current-account‖ balance) has
stayed negative for many years. But a country with a current account deficit pays for it by either
piling up debts or giving up assets to foreigners. Such a country is exporting paper IOUs, such as
bonds, that are a present claim on future goods and services. The value of these net exports of
paper IOUs matches the value of the ordinary current account deficit.
There is no need to add paper bonds to our wheat-and-cloth examples because the bonds are a
claim on future wheat and cloth. Today the United States may be importing more cloth than it is
exporting wheat, but this deficit is matched by the expected value of its net exports of extra
wheat someday when it pays off the debt. Trade is expected to balance over the very long run.
That expectation could prove wrong in the future: Maybe the United States will default on some
of its foreign debts, or maybe price inflation (deflation) will make it give up less (more) wheat
than expected. Still, today‘s transactions are based on the expectation that trade will balance in
the long run.

CASE STUDY
The real world does in fact reveal the behavior portrayed in the discussion of this module.
Countries do react to the opening of trade in the ways predicted by economits.
A good example is China‘s progression to becoming a major trading nation after the near total
isolation and self-sufficiency that Chairman Mao imposed between 1958 (at the start of the Great
Leap Forward) and 1976 (the year of Mao‘s death and the end of the Great Proletarian Cultural
Revolution). Though China covers a huge geographic area, it is not a land-abundant country.
Rather, it is labor-abundant and land-scarce. True to the ancient Chinese saying ―Many people,
little land,‖ the country has about 19 percent of the world‘s population but only about 10 percent
of its farmable land. For such a labor-abundant country, the trade theories would predict the
following responses to the chance to trade with the rest of the world:
• China should export labor-intensive products like clothing and import land-intensive products
like wheat.
• China should shift resources out of producing land-intensive products like wheat and into
producing labor-intensive products like clothing.
• China‘s production specialization should be incomplete. The country should go on producing

some land-intensive products, though these should be a lower share of production than before.
• China should be a more prosperous country with trade than without trade. The theory even
allows for the possibility that China could consume more of all goods, including both wheat and
clothing.
All these predictions have been coming true in China since 1976. The trade pattern is what we
would expect: China has become a strong exporter of all sorts of manufactured products,
including clothing, that take advantage of the country‘s abundant labor supply. China has also
turned to imports for a portion of its consumption of land-intensive products, including wheat.
All over China, people have noticed the shift of production out of agriculture and into export-
oriented industry. For example, in the crowded countryside of Shandong province, villages that
once struggled with poor soil to grow wheat and corn for cities like Tianjin and Beijing have

abandoned farming and now make furniture and pharmaceuticals. Even the relatively fertile
villages of Jiangsu province, near the mouth of the Yangtse River, make textiles, steel, and other
industrial goods. Similarly, in the south, Guangdong province used to send its rice north to
Beijing. Now Guangdong, a leader in China‘s rapid industrialization, consumes more rice than it
produces, supplementing local crops with rice imports from Thailand.
Both public opinion and the available statistics agree that the great majority of China‘s
population have gained purchasing power.
Some Chinese do fear becoming dependent on imports of food. The fears seem to be greater in
the government than in the population at large. The government in the 1990s decided to channel
a larger share of taxpayers‘ money into promoting agricultural production, to retard the shift
away from being self-sufficient in food. Yet many are less worried. Wu Xiedong, leader of one
of those Jiangsu villages that switched from growing grain to making textiles and steel, is
optimistic about the shift.
As he put it in 1995, ―As long as the present policy that allows farmers to go into industry
doesn‘t change, we will continue to grow very fast.‖ As for relying on imported food, Wu says,
―America has lots of grain, right? If America buys my steel, I‘ll buy America‘s grain. Then we
can all get rich.‖
China‘s experience mirrors what happened earlier to Japan, Korea, Taiwan, and Hong Kong.All
of these labor-abundant and land-scarce areas reacted to the opening of trade by shifting into
labor-intensive industry and out of land intensive agriculture, and all of them prospered.

CASE STUDY
What we now know about the mixtures of productive factors that make up the exports and
imports of leading nations, has been learned largely because Wassily Leontief was puzzled in the
1950s.
Leontief, a Nobel Prize winner in economics, set off a generation of fruitful debate by following
the soundest of scientific instincts: testing whether the predictions of a theory really fit the facts.
Leontief decided to test the Heckscher–Ohlin theory that countries will export products whose
production requires more of the country‘s abundant factors and import products whose
production relies more on the country‘s scarce factors.
He assumed that the U.S. economy at that time was capital-abundant (and labor-scarce) relative
to the rest of the world.
LEONTIEF‘S K / L TEST
Leontief computed the ratios of capital stocks to numbers of workers in the U.S. export and
import-competing industries in 1947. This computation required figuring out not only how much
capital and labor were used directly in each of these several dozen industries but also how much
capital and labor were used in producing the materials purchased from other industries. As the
main pioneer in input–output analysis, he had the advantage of knowing just how to multiply the
input–output matrix of the U.S. economy by vectors of capital and labor inputs, export values,
and import values to derive the desired estimates of capital/labor ratios in exports and import
competing production. So the test of the H–O theory was set. If the United States was relatively
capital-abundant, then the U.S. export bundle should embody a higher capital/labor ratio ( K x /
L x ) than the capital/labor ratio embodied in the U.S. production that competed with imports ( K
m / L m ).
Leontief‘s results posed a paradox that puzzled him and others: In 1947, the United States was
exporting relatively labor-intensive goods to the rest of the world in exchange for relatively
capital-intensive imports! The key ratio ( K x / L x )/( K m / L m ) was only 0.77 when H–O said
it should be well above unity. Other studies confirmed the bothersome Leontief paradox for the
United States between World War II and 1970.

BROADER AND BETTER TESTS
The most fruitful response to the paradox was to introduce other factors of production besides
just capital and labor. Perhaps, reasoned many economists (including Leontief himself), we
should make use of the fact that there are different kinds of labor, different kinds of natural
resources, different kinds of capital, and so forth. Broader calculations of factor content have
paid off in extra insights into the basis for U.S. trade. True, the United States was somewhat
capital-abundant, yet it failed to export capital-intensive products. But the post-Leontief studies
showed that the United States was also abundant in farmland and highly skilled labor.
And the United States was indeed a net exporter of products that use these factors intensively, as
H–O predicts.
DISCUSSION QUESTION
When Leontief published his results, should economists have abandoned Heckscher–Ohlin as a
theory of international trade?

The U.S. Pattern
Figure above shows the factor content of U.S. exports and of U.S. imports competing with
domestic production. Overall, labor incomes account for a greater share of the value of U.S.
exports than of the value of U.S. imports. This reflects two facts. First, the number of jobs
associated with U.S. exports is about the same as the number associated with an equal value of
imports.

Second, the average skill and pay levels are higher on the export side. In fact, it seems wise to
divide labor into at least two types—skilled and unskilled.
Skilled labor in the United States is an export-oriented factor, while unskilled labor is an import-
competing factor. Farmland is another export-oriented factor. Physical capital (as suggested by
the Leontief paradox) and mineral rights generally are importcompeting factors.

The Canadian Pattern
Canada, by contrast, implicitly exports and imports the factor mixtures sketched in Figure above.
One clear similarity to the U.S. pattern is that both countries are net exporters of the services of
farmland through their positions as major grain exporters.
Another similarity is that Canada is a net importer of unskilled labor. In contrast to the United
States, Canada is a net importer of labor overall and a slight net exporter of nonhuman capital.
Finally, Canada is a heavy net exporter of mineral-rights services through its exports of both the
minerals extracted from the ground and manufactured products made with these minerals.

CASE STUDY
One of the most striking features of the global economy is the rise of China as a trading force
after it opened to international trade beginning in the 1970s. China accounted for less than 1
percent of international trade in 1980. Its exports and imports have grown rapidly, so that by
2012 China‘s trade averaged over 9 percent of world trade.
Many media stories and commentators make it sound as though China is a ruthless mercantilist
trader, focused on exporting its way to economic success. But the actual evidence is quite
different.
China is much closer to fitting our presumption that changes in export values roughly match
changes in import values, so that trade is close to being balanced over time. The figure on the
next page shows the paths of the value of exports and value of imports for China during 1976–
2012.
The rapid growth is evident. It is also clear that the value of exports almost exactly equaled the
value of imports up to about 1996. While exports and imports continued to grow rapidly, exports
exceeded imports by a moderate amount each year from 1996 to 2004. Then the gap increased to
about $350 billion in 2008, before declining to about $230 billion in 2012. Still, with generally
rapid growth in both exports and imports, China‘s trade expansion is closer to the textbook
model of balanced overall trade than it is to an export-only mercantilism.
What does China trade? Do the patterns across export and import products match with what the
Heckscher–Ohlin theory predicts? China is relatively abundant in medium-skilled labor, and it is
relatively scarce in forestland, crop land, and highly skilled labor.
We also know that China is relatively scarce in most natural resources in the ground. The table
below lists some representative products in China‘s international trade in 2012.
As is true for other countries, much but not all of China‘s international trade is consistent with
the Heckscher–Ohlin theory. First, the theory predicts that China will be a net importer of land-

intensive agricultural products like soybeans. Second, the theory predicts that China will be a net
importer of natural resources like metal ores and crude petroleum.
Third, the theory predicts that China will be a net importer of skilled-labor-intensive
manufactured products like metalworking machinery, electronic microcircuits, and aircrafts.
Fourth, the theory predicts that China will be a net exporter of lower-skilled-labor-intensive
products like clothing, footwear, and toys.
But then we are left with a fifth group that appears superficially puzzling. Why is China a net
exporter of such products as computers and audio equipment? Here we must be careful to note
that the part of the production process that occurs in China is mainly the assembly of these
products, and the assembly processes use lowerskilled labor intensively. Essentially, China is a
net importer of the materials and components that go into these products (as well as importing
the product designs and the machinery used in production).
China‘s production focuses on using its abundant less-skilled and medium-skilled workers to
assemble the final products, which are then exported.
While much of China‘s international trade does match with the Heckscher–Ohlin theory, there
are some products that do not, including vegetables and textile machinery, as shown at the
bottom of the listing.
Overall, China fits our textbook stories remark ably well. First, its trade has been roughly
balanced—the value of exports has roughly equaled the value of imports, even though both are
growing rapidly. Second, much of its pattern of net exports and net imports of different products
is just what Heckscher and Ohlin would predict.

CASE STUDY
The U.S. Congress has sometimes come close to passing comprehensive bills to slash U.S.
imports through tariffs or other barriers. These attempts have been defended as necessary to
protect U.S. jobs. Does more trade mean fewer U.S. jobs? Does less trade mean more U.S. jobs?
Economists have developed a relatively clear and surprising answer.
Consider general restrictions that reduce U.S. imports across the board. Such restrictions are
likely to result in no increase in U.S. jobs at given wage rates! This is because (1) reducing U.S.
imports also tends to reduce U.S. exports and (2) the average job content of U.S. exports is about
equal to that of U.S. imports.

There are four reasons to think that reducing imports reduces exports. First, exports use
importable inputs. If these imports are not so readily available, U.S. exports become less
competitive.
Second, foreigners who lose sales to us cannot buy so much from us. As foreigners lose income
from exports to us, they buy less of many things, including less of our exports. Third, foreign
governments may retaliate by increasing their own protection against imports. U.S. exports
decline as they face additional foreign barriers.
Fourth, cutting our imports may create pressures for changes in exchange rates. Here, we depart
briefly from barter trade to recognize that most trade is paid for with national currencies.
Reducing demand for imports also reduces demand for foreign currencies used to pay for the
imports. If the foreign currencies then lose value— thus increasing the exchange-rate value of
the U.S. dollar—the higher dollar value tends to make U.S. goods more expensive to foreign
buyers. In response they buy less of our exports.
The combination of these four effects results in roughly a dollar-for-dollar cut in exports if
imports are cut. If both exports and imports are cut, the effect on U.S. jobs then depends on
whether more jobs are created in the expanding import competing industries than are lost in the
decliningexport industries. Estimates from different studies vary somewhat. Overall, the studies
indicate that the net change in total jobs would probably be small if U.S. imports and U.S.
exports decreased by the same amount. (In addition, the average wage rate tends to be higher in
export industries.)
If a sweeping cut in imports would probably not increase jobs much, why would labor groups
favor such import cuts? The largest lobbyist for protection against imports is the American
Federation of Labor–Congress of Industrial Organizations (AFL– CIO). The goods-sector
membership of this organization is concentrated in industries that are more affected by import
competition than is the economy (or labor) as a whole. It is practical for the AFL–CIO to lobby
for protectionist bills that would defend the jobs of AFL–CIO members and their wages even if
these bills would cost many jobs and wages outside of this labor group. To understand who is
pushing for protection, it is important to know whose incomes are most tied to competition from
imports.

This discussion refers to a general restriction against U.S. imports. Selective barriers against
specific imports would alter the net effect on U.S. jobs. For instance, studies of existing U.S.
barriers, which are selective, show that they are most restrictive on goods having a higher-than
average jobs content, especially in less-skilled jobs categories. Thus, existing U.S. import
barriers may bring some increase in U.S. jobs, even though raising new barriers against all
imports probably would not increase U.S. jobs.
We conclude by noting that the validity of focusing on jobs gained and lost through trade is itself
debatable. Jobs gained or lost through changes in international trade are themselves a small part
of overall changes in jobs in the economy. Many different sources of pressure for change,
including shifts in demand and changes in technologies result in changes in the number and types
of jobs in the country. A well-functioning economy is dynamic—employment shifts between
sectors to reallocate workers (and other resources) to their highest-value uses. While there are
disruptions in the short run, the reallocations are crucial to economic growth
CASE STUDY
The analysis of monopolistic competition focuses on the market for a type of differentiated
product and examines the number of variants or models and the price of a typical variant.
We can also picture what is happening to an individual firm—say, Ford—and its unique
model— say, the Focus. By analyzing an individual firm in a monopolistically competitive
market, we add depth to the analysis. We can better understand both the effects of entry and how
the number of models is linked to the price of the typical model.
FROM MONOPOLY TO MONOPOLISTIC COMPETITION
Consider Ford and its model the Focus. We presume that moderate scale economies are of some
importance, so the (long-run) average cost (AC) curve for producing the Focus is downward
sloping, as shown in the graphs in this box. If average cost is falling, then we know that marginal
cost is less than average cost. The exact shape of the marginal cost (MC) curve depends on
production technology, and a reasonable shape for the MC curve is shown in the graphs.
To get started on the analysis, let‘s assume that the Ford Focus is the only compact car model
offered in this market, so Ford has a pure monopoly. The demand for the Focus as the only

compact car is strong, with the demand curve D0 shown in the graph on the left at the top of the
facing page. We assume that Ford sets one price to all buyers of the Focus during a period of
time.
Then, the marginal revenue for selling another car during this time period is less than the price
the buyer pays for this car because Ford must lower the price to all other buyers to sell this one
additional car. The marginal revenue curve (MR0) is below the corresponding demand curve D0.
How will Ford use its monopoly power to maximize its profit? Profit is the difference between
revenue and cost, so Ford should produce and sell all units for which marginal revenue exceeds
marginal cost. Maximum profit occurs when marginal revenue equals marginal cost, at point F in
the graph, so Ford should produce and sell 1.2 million cars per year. Using the demand curve at
point G,
Ford should set a price of $31,000 per car to sell the 1.2 million cars. The price of $31,000 per
car exceeds the average cost of producing 1.2 million cars, shown in the graph as $15,000 per
car. Ford earns total economic profit of $19.2 billion (equal to $16,000 per car times 1.2 million
cars).
Will this high profit last? Other firms can see Ford‘s sales and its high profit. If entry is easy,
then other firms will offer new, similar models. Here comes the competition part of monopolistic
competition.
As other firms offer similar models, some of what had been demand for the Focus is lost as some
buyers shift to the new rival models. In addition, the increased availability of close substitutes
probably increases the price elasticity of demand for the Focus. As a result of the entry of new
competing models, the demand curve for the Focus shifts down and becomes somewhat flatter. If
entry of new models is easy, then this process continues as long as there are positive profits that
continue to attract entry. Entry stops only when economic profit is driven to zero, for Ford and
its Focus (and for other firms producing competing models).
The graph on the top right side shows both the initial demand curve D0 for the Focus monopoly
and the new shrunken and flatter demand curve D1 for the Focus after the entry of rival models.
The Focus is still a unique model, and Ford still has some pricing power (the demand curve D1 is

still downward sloping). However, the best that Ford can do in the new longrun equilibrium of
this monopolistically competitive market is to operate at point J. Ford sells 0.8 million cars at a
price of $19,000 per car.
Price equals average cost, and Ford earns zero economic profit.
FROM NO TRADE TO FREE TRADE
Assume that the monopolistic competition equilibrium for Ford shown in the top right-hand
graph is part of the U.S. market equilibrium with no trade. What happens to Ford and its Focus
when the U.S. market is opened to free trade with the rest of the world? Ford can now export
Focuses to foreign buyers, and Ford faces new competition from imports of foreign models.
Essentially, with free trade Ford is now part of a larger and more competitive world market for
compact cars With even more substitute models now available, demand for the Ford Focus
becomes even more price elastic. And in the new long-run monopolistically competitive
equilibrium with free trade, Ford still earns zero economic profit.
The graph at the right shows both the no-trade equilibrium for Ford and the new free-trade
equilibrium. The new demand curve D2 shows the combined U.S. and foreign demand for the
Focus with free trade. In comparison with the no-trade demand curve D1, the free-trade D2 is
somewhat flatter because of the larger number of competing models that are available (both U.S.
and foreign models).
In the new free-trade zero-profit equilibrium, the price of the Ford Focus is down to $17,000 per
car, and Ford produces and sells 1 million cars per year, some to U.S. buyers and some to foreign
buyers. With price equal to average cost at point L, Ford earns zero economic profit.

Rather, in this setting a country‘s trade is based on product differentiation.
• The basis for exporting is the domestic production of unique models demanded by some
consumers in foreign markets.
• The basis for importing is the demand by some domestic consumers for unique models
produced by foreign firms.

• Intra-industry trade in differentiated products can be large, even between countries that are
similar in their general production capabilities.
Scale economies play a supporting role, by encouraging production specialization for different
models. Firms in each country produce only a limited number of varieties of the basic product.
In addition to intra-industry trade, this product may also have some net trade—that is, the United
States may be either a net exporter or a net importer of compact cars.
The basis for the net trade can be comparative advantage.
Figure below provides an example of how net trade and intra-industry trade can coexist. We
modify the world that we used in previous chapters slightly, so the two products are wheat and
compact cars. Wheat is relatively land-intensive in production, and compact cars are relatively
labor-intensive in production. Wheat is assumed to be a commodity, with no product
differentiation, and compact cars are differentiated by model. The United States is relatively
land-abundant and labor-scarce. Here is the pattern of trade that we predict. First, the Heckscher–
Ohlin theory explains net trade, with the United States being a net exporter of wheat ($40 billion)
and net importer of compact cars (also $40 billion, equal to the difference between the $30
billion of U.S. exports and the $70 billion of U.S. imports). Second, intra-industry trade is driven
by product differentiation.
For the commodity wheat, there is no intra-industry trade. For compact cars, differentiated by
models, there is $60 billion of intra-industry trade, equal to the difference between the $100
billion of total trade in compact cars and the $40 billion of net trade.
The share of intra-industry trade in total compact car trade is 60 percent ($60 billion of intra-
industry trade as a percentage of the $100 billion of total trade).
Once we recognize product differentiation and the competitive marketing activities that go with
it (for instance, styling, advertising, and service), net trade in an industry‘s products can also
reflect other differences between countries and their firms. Net trade in a product can be the
result of differences in international marketing capabilities.

Or it can reflect shifting consumer tastes, given the history of choices of whichspecific varieties
are produced by each country. For instance, Japanese firms focusedon smaller car models, and
they benefited from a consumer shift toward smaller carsin the United States following the oil
price shocks of the 1970s. Japanese auto producersalso marketed their cars skillfully and
developed a reputation for high qualityat reasonable prices. Japan developed large net exports in
automobile trade with theUnited States during the 1970s and 1980s. Some of this was the result
of comparative cost advantages, but another part was the result of focusing on smaller cars at the
right time and skillful marketing. The United States has net exports of wheat of $40 billion and
net imports of compact cars of $40 billion. There is also substantial intra-industry trade in
compact cars, with the IIT share equal to 60 percent of total trade in compact cars.

Product differentiation, monopolistic competition, and intra-industry trade add major insights
into the national gains from trade and the effects of trade on the well-being of different groups in
the country. A major additional source of national gains from trade is the increase in the number
of varieties of products that become available to consumers through imports, when the country
opens to trade. For instance, the economic wellbeing of U.S. consumers increases when they can
choose to purchase an automobile not only from the domestic models such as the Ford Focus but
also from imported foreign models such as the Mini Cooper because some may prefer the Mini
Cooper.
How large might the gains from greater variety be? Broda and Weinstein (2006) look at very
detailed data on imports into the United States during 1972 to 2001 to develop an estimate. They
conclude that the number of imported varieties more than tripled during this time period. They
use estimates of how different the new varieties are to determine how much U.S. consumers
gained from access to the new varieties. (The more different, the more the gain.) By 2001 the
gain to the United States was about $260 billion per year, close to an average gain of $1,000 per
person.
Feenstra (2010) estimated that, as of 1996, the greater product variety obtained through
international trade increased world well-being by an amount equal to about 12.5 percent of
global GDP. If that 12.5 percent is still roughly correct, the increase in world well-being
currently is about $10 trillion per year.
These national gains from greater variety accrue to consumers generally. They can be added to
trade‘s other effects on the well-being of different groups within the country. Two additional
insights result.
First, the opening (or expansion) of trade has little impact on the domestic distribution of factor
income if the (additional) trade is intra-industry. Because extra exports occur as imports take part
of the domestic market, the total output of the domestic industry is not changed much. There is
little of the inter-industry shifts in production that put pressures on factor prices. Instead, with the
expansion of intra-industry trade, all groups can gain from the additional trade because of gains
from additional product variety. A good example is the large increase of trade in manufactured
goods within the European Union during the past halfcentury.

Much of the increase was expansion of intra-industry trade, so the rapid growth of trade actually
led to few political complaints.
Second, gains from greater variety can offset any losses in factor income resulting from
interindustry shifts in production that do occur. Groups that appear to lose real income as a result
of Stolper–Samuelson effects will not lose as much; and they could actually believe that their
well-being is enhanced overall if they value the access to greater product variety that trade
brings. For instance, many people would be willing to give up a few dollars of annual income to
continue to have numerous models of imported automobiles available for purchase.
Research pioneered by Melitz (2003) and Bernard et al. (2003) indicates yet another source of
additional gains from trade, assuming (realistically) that firms in each country differ somewhat
by cost levels (or quality levels) for their product models.
With no trade, firms with different levels of cost can coexist, with lower-cost firms having lower
prices and larger market shares. When the country opens to trade in this type of product, the
increased global competition causes the demand curve facing a typical firm to become flatter and
the typical price declines. In the more competitive global market, high-cost (or low-quality)
national firms cannot compete and go out of business. Lower-cost firms can compete and export,
so their production levels increase. Thus, opening to trade favors the survival and expansion of
firms with lower cost levels (or higher levels of product quality).
We see a new way in which international trade drives national production toward firms with low
opportunity costs. For comparative advantage trade (Ricardian or Heckscher–Ohlin), the
restructuring is across different industries. For monopolistic competition trade, the restructuring
is across firms of differing capabilities within the industry.
CASE STUDY
Another way of looking at international trade is to examine total exports and total imports
between pairs of countries. That is, for a country like Australia, which countries does it export to
and which countries does it import from?

Australia exports mainly primary products, including coal and iron ore. The top 10 destination
countries for its exports in 2012, in orderfrom the largest down, were China, Japan, South Korea,
India, the United States, Taiwan, New Zealand, Singapore, Britain, and Malaysia.
Australia imports mainly manufactured products, including automobiles, machinery, and

computers, as well as crude and refined petroleum.
The top 10 source countries, again starting with the largest, were China, the United States, Japan,
Singapore, Germany, Thailand, SouthKorea, Malaysia, New Zealand, and Britain. In looking at
these lists, we can note threethings. The first is that they are mostly the same countries in the two
lists. Eight of the top 10 are the same. The second is that many of these countries, including the
United States, Japan, China, Britain, and Germany, have large economies.
The third is that New Zealand is in both lists. Although New Zealand has a small economy, it is
geographically close to Australia.
When we look at other countries, we see similar patterns for their major trading partners. Such
observations have led to the development of the gravity model of trade, so called because it has
similarity to Newton‘s law of gravity, which states that the force of gravity between two objects
is larger as the sizes of the two objects are larger, and as the distance between them is smaller.
The gravity model of international trade posits that trade flows between two countries will be
larger as
• The economic sizes of the two countries are larger.
• The geographic distance between them is smaller.
• Other impediments to trade are smaller.
In statistical analysis of data on trade between pairs of countries, the gravity model explains the
patterns very well. Let‘s look at what we know and learn about each of these determinants.
ECONOMIC SIZE
Our theory of trade based on product differentiation and monopolistic competition can explain
why the economic sizes of the countries matter. Consider first differences across the importing

countries. Using basic demand analysis, we expect that an importing country that has a larger
national income will buy (as imports) more of the product varieties produced in other countries.
Now consider differences across the exporting countries. If the exporting country has a larger
overall production capability, then it will have the resources to produce a larger number of
varieties of the products. With more varieties offered to foreign buyers, it will sell more (as
exports) to these foreigners.
Economic size is usually measured by a country‘s gross domestic product (GDP), which
represents both its production capability and the income that is generated by its production.
Consider Australia‘s trade with the United States and Canada. U.S. GDP is about nine times that
of Canada, and Australia trades about nine times as much with the United States as it does with
Canada. In statistical analysis, the elasticity of trade values with respect to country size (GDP) is
usually found to be about 1 (so that, for instance, a country with twice the GDP tends to do twice
the trade with a particular partner country, other things being equal).
DISTANCE
Most obviously, distance shows the importance of a cost that we have generally ignored in our
theoretical analysis, the cost of transporting goods internationally. It costs more to transport
goods longer distances. Consider Australia‘strade with New Zealand and Ireland, the latter a
country that is over seven times as far from Australia as is New Zealand. Even though Ireland‘s
GDP is larger than that of New Zealand, Australia‘s trade with Ireland is only one-ninth that of
its trade with New Zealand. (Not all of this huge trade difference is due to the large difference in
distances because Australia and New Zealand also have a preferential trade agreement, but much
of the difference is due to distance.)
In statistical analysis, a typical finding is that a doubling of distance between partner countries
tends to reduce the trade between them by one-third to one-half. This is actually a surprisingly
large effect, one that cannot be explained by the monetary costs of transport alone because these
costs are not that high. This finding has led us to think about other reasons why distance matters.
One set of reasons is that countries that are closer tend to have more similar cultures and a
greater amount of shared history, so the costs of obtaining information about closer trade

partners are lower. Another set of reasons focuses on risk. Shipping things a longer distance,
especially by ocean transport, takes a longer time. The longer time for shipment could lead to
greater risks that the goods would be physically damaged or deteriorate. In addition, there is a
greater risk that conditions could change in the importing country. For instance, the styles that
are in fashion could change, or the importer could go bankrupt.
OTHER IMPEDIMENTS
Government policies like tariffs can place impediments to trade and the gravity model can show
how these reduce trade between countries. Perhaps the most remarkable finding from statistical
analysis using the gravity model is that national borders matter much more than can be explained
by government policy barriers. Even for trade between the United States and Canada, this border
effect is very large. A series of studies (starting with McCallum [1995] and including Anderson
and van Wincoop [2003]) have used the gravity model to examine inter-provincial trade within
Canada, interstate trade within the United States, and international trade between Canadian
provinces and U.S. states. As usual, province and state GDPs are important, as are distances
between them. The key finding is that there is also an astounding 44 percent less international
trade than there would be if the provinces and states were part of the same country. This
extremely large border effect exists even though any government barriers are generally very low,
and it is not easy to see what the other impediments could be.
There‘s something about the national border. For Canada, the result is that provinces trade much
more with each other and much less with U.S. states.
The gravity model has been used to examine the effects of many other kinds of impediments (or
removal of impediments) to trade. Let‘s conclude with a sampling of some of the results:
• Countries that share a common language trade more with each other.
• Countries that have historical links (for example, colonial) trade more with each other.
• A country trades more with other countries that are the sources of large numbers of its
immigrants.
• Countries that are members of a preferential trade area trade more with each other.

• Countries that have a common currency trade more with each other.
• A country with a higher degree of government corruption, or with weaker legal enforcement of
business contracts, trades less with other countries.
OLIGOPOLY AND TRADE
Monopolistic competition is a mild form of imperfect competition, but still one that has large
implications for international trade. Oligopoly, the second type of imperfect competition
examined in this chapter, is a stronger form. Some important industries in the world are
dominated by a few large firms. Two firms, Boeing and Airbus, account for nearly all the
world‘s production of large commercial aircraft. Three firms, Sony, Nintendo, and Microsoft,
design and sell most of the world‘s video game consoles. Three firms, Companhia Vale do Rio
Doce (CVRD), Rio Tinto, and BHP Billiton, mine more than half of the world‘s iron ore. Such
concentration of production and sales in a few large firms is a major deviation from one of the
assumptions of perfect competition, that there are a large number of small firms competing for
sales in the market.
An industry in which a few firms account for most of the world‘s production is a global
oligopoly. (In the extreme, one firm would dominate the global market—a global monopoly.
Microsoft in operating systems for personal computers is an example.) How does global
oligopoly (or monopoly) alter our understanding of international trade? We focus here on two
aspects. First, there are implications of substantial scale economies for the pattern of trade.
Second, there are implications of oligopoly (or monopoly) pricing for the division of the global
gains from trade.
Substantial Scale Economies
Exploiting substantial internal scale economies is an explanation for why a few large firms come
to dominate some industries. If substantial scale economies exist over a large range of output,
then production of a product tends to be concentrated in a few large facilities in a few countries,
to take full advantage of the cost-reducing benefits of the scale economies. (In the extreme,
production would be in one factory in a single country.) These countries will then tend to be net
exporters of the product, while other countries are net importers. An example is the large civilian

aircraft industry. Boeing concentrates most of its aircraft production in the United States, and
Airbus concentrates most of its aircraft production in Western Europe. Why do we see this
pattern of producing-exporting countries and importing countries?
History matters. Firms initially chose these production locations for a number of reasons. One
prominent reason usually was comparative advantage—the companies could achieve low-cost
production with access to required factor inputs at these locations.
However, even if a location initially was consistent with comparative advantage, cost conditions
can change over time. Yet, the previously established pattern of production and trade can persist
even if other countries could produce more cheaply. To see why, start with the fact that the
established locations are already producing at large scale and have fairly low costs because they
are achieving scale economies. Now consider the potential new location. The shifting
comparative advantage can provide the new location with lower cost based on factor prices and
factor availability, but that source of cost advantage may not be enough. To be competitive on
costs with the established locations, the production level at this new location would also have to
be large enough to gain the cost benefits of most of the scale economies. This may not be
possible without an extended period of losses because (1) the increase in quantity supplied would
lower prices by a large amount or (2) established firms in other locations may fight the entrant
using (proactive) price cuts or other competitive weapons.
With the risk of substantial losses, production in this potentially lower-cost location may fail to
develop.
Oligopoly Pricing
Each large firm in an oligopoly knows that it is competing with a few other large firms. It knows
that any action that it takes (such as lowering its price, increasing its advertising, or introducing a
new product model) is likely to provoke reactions from its rivals. We can model this
interdependence as a game.
Consider an example. Picture price competition between two dominant large firms as a choice
for each firm between competing aggressively (setting a low price) or restraining its competition
(setting a high price). The outcome of the game depends on which strategy each firm chooses.

The best outcome for the two firms together is usually to restrain their price competition. They
both can charge high, monopoly-like prices and earn substantial economic profits. However, if
they cannot cooperate with each other, then the play of the game may result in both competing
aggressively, and each earning rather low profits. To see why, imagine what could happen if one
firm decides to restrain its competition and to set a high price. The other firm often has an
incentive to compete by setting a lower price because it can increase its sales so much that it
earns even more profit than it would earn by also setting a high price.
The high-price firm loses sales and may earn very low profits. Both know the other is likely to
act this way, so neither is willing to set a high price. Both compete aggressively with low prices,
and both earn low profits. They are caught in what is called a prisoners‘ dilemma.
The firms can attempt to find a way out of the dilemma by cooperating to restrain their
competition. The cooperation may be by formal agreement (though such a cartel arrangement is
illegal in the United States and many other countries). The cooperation could be tacit or implicit,
based on recognition of mutual interests and on patterns of behavior established over time. If
they can cooperate, then they can both earn high profits. But the cooperation is often in danger of
breaking down because each firm still has the incentive to cheat by lowering its price, to try to
earn even higher profit.
Although game theory does not say for sure what is the outcome of this kind of game, it does
highlight that cooperating with rivals is possible (though not assured) in an oligopoly. Firms in
an oligopoly can earn economic profits, and these profits can be substantial if competition is
restrained.
Pricing, matters for the division of the global gains from trade. To see this, focus on export sales
by the oligopoly firms. If the oligopoly firms compete aggressively on price, then more of the
gains from trade go to the foreign buyers and less is captured by the oligopoly firms. If, instead,
the oligopoly firms can restrain their price competition, then the oligopoly firms can earn large
economic profits on their export sales. If a firm located in a country can charge high prices on its
exports and earn high profits on its export sales, there are two related effects. First, the high
export prices enhance the exporting country‘s terms of trade. Second, the high profits add to the
exporting country‘s national income by capturing some of what would have been the consumer

surplus of foreign buyers. More of the gains from trade go to the exporting country (or, perhaps
more precisely, to the country or countries of the owners of the oligopoly firms), and less to the
foreign buyers.
Putting all of this together, we see that the current pattern of national production locations for a
global oligopoly may be somewhat arbitrary, and that the small number of countries that have the
industry‘s production may obtain additional gains from trade if the firms in these countries can
earn substantial economic profits on their exports.
The national gain from having high-profit oligopoly firms in a country is a basis for national
governments to try to establish local firms in the oligopoly industry or to expand the industry‘s
local production and exporting.
EXTERNAL SCALE ECONOMIES AND TRADE
Now let‘s turn to examine an industry that benefits from substantial external scale economies, as
our third form of market structure that deviates from the standard case of perfect competition.
External scale economies exist when the expansion of the entire industry‘s production within a
geographic area lowers the long-run average cost for each firm in the industry in the area.
External scale economies are also called agglomeration economies, indicating the cost
advantages to firms that locate close to each other. Examples of industries and locations that
benefit from external scale economies include filmmaking in Hollywood, computer and related
high-tech businesses in Silicon Valley, watch-making in Switzerland, and financial services in
London.
To focus on the effects of external scale economies, we will conduct our formal analysis using
the assumption that a large number of small firms exist in the industry in each location. That is,
we assume that there are no (or only modest) internal scale economies, so that an individual firm
does not need to be large to achieve low cost. We then have a case in which substantial external
scale economies coexist with a highly competitive industry.
If expansion of an industry in a location lowers cost for all firms in that location, then new export
opportunities (or any other source of demand growth) can have dramatic effect. Figure below
pictures a national semiconductor industry that is competitive, but characterized by external scale

economies. There is an initial equilibrium at point A, with many firms competing to sell 40
million units at $19 a unit. Here, the usual short-run supply and demand curves ( S 1 and D 1 )
intersect in the usual way. The upward-sloping national supply curve is the sum of each small
individual firm‘s view of its own costs. Each firm operates at given levels of industry production,
which it cannot by itself affect very much. It reacts to a change in price according to its own
upward-sloping supply curve, which is also its own upward-sloping marginal cost curve. The
sum of these individual-firm supply curves is shown as national supply curve S 1 .
What is new in the diagram is the coexistence of the upward-sloping short-run national supply
curve S 1 with the downward-sloping long-run average cost curve, which includes the cost-
reducing effects of the external scale economies. The national industry‘s downward-sloping
average cost curve comes into play when demand shifts.
To bring out points about international trade, let us imagine that opening up a new export market
shifts overall demand from D l to D 2 . Each firm would respond to the stronger demand by
raising output. If each national firm acted alone and affected only itself, the extra demand would
push the market up the national supply curve S l to a point like B . The new export business
raises the national industry‘s output, here initially from 40 at point A to 46 at point B . The
increase in industry output brings additional external economies. For instance, there could be
more development and exchange of useful information, which raises productivity and cuts costs
throughout the national industry. This means, in effect, a sustained rightward movement of the
national industry short-run supply curve, for instance, to S2 in the new long-run equilibrium.
To portray the cost-cutting more conveniently than with multiple shifts of the supply curve, we
can follow the national industry‘s long-run average cost curve, including external economies.
The external economies lead to a decline in average cost as national industry output expands. As
Figure below is drawn, we imagine that demand and supply expansion catch up with each other
at point C , the new long-run equilibrium.
What are the welfare effects of the opening of trade for an industry with external economies?
Producers of the product in an exporting country tend to gain producer surplus as a result of the
expansion of industry output, although the decline in price will mitigate the gain. Producers in
importing countries lose producer surplus.

Consumers in the importing countries gain consumer surplus as price declines and their
consumption increases. Consumers in the exporting country also gain consumersurplus as price
declines and consumption quantity increases. Here, is a definite contrast to the standard case,
where local buyers suffer from price increases on goods that become exportable with the opening
of trade.
What explains the pattern of trade that emerges in industries subject to external scale economies?
Many of the issues are similar to those raised with respect to substantial internal scale
economies. With no trade, each country must produce for its own consumption. If trade is

opened, production tends to be concentrated in a small number of locations. Clusters of firms in
some locations will expand production, as shown in Figure, and countries with these locations
will export the product. In other countries, production will shrink or cease, and these countries
will import the product.
It is not easy to predict which locations will expand and which will shrink or cease production.
Sometimes it appears to be luck, with firms in one location deciding to expand at the right time
to take the lead. Swiss watch-making seems roughly to fit. Or the size of the domestic market
with no trade may be important if the larger domestic market permits domestic firms to be low-
cost producers when trade is opened. Hollywood seemed to benefit from the early large size of
the U.S. market for films. Or a push from government policy may be important. Early in its
development Silicon Valley benefited from selling to the U.S. government for defense and
aerospace applications. The outcome is analogous to the production of pearls. Which oysters
produce pearls depends on luck or outside human intervention. An oyster gets its pearl from the
accidental deposit of a grain of sand or from a human‘s introducing a grain of sand.
The external-economies case is one in which a lasting production advantage in an industry can
be acquired by luck or policy even if there are no differences in countries‘ initial comparative
advantages. The production locations and pattern of trade tend to persist even if other locations
are potentially lower-cost. Other locations cannot easily overcome the scale advantages of
established locations. As we also noted for the case for substantial internal scale economies, the
government of an importing country may conclude that there is a basis for infant-industry
policies that nurture the local development of the industry.
CASE STUDY
Developing a new exportable natural resource can cause problems such as the problem of
―immiserizing growth‖: If you are already exporting and your export expansion lowers the world
price of your exports, you could end up worse off. A second is the apparent problem called the
Dutch disease, in which new production of a natural resource results in a decline in production of
manufactured products (deindustrialization).

For the Netherlands, the origin of the disease was the development of new natural gas fields
under the North Sea. It seemed that the more the Netherlands developed its natural gas
production, the more depressed its manufacturers of traded goods became. Even the windfall
price increases that the two oil shocks offered the Netherlands (all fuel prices skyrocketed,
including that for natural gas) seemed to add to industry‘s slump.
The Dutch disease has been thought to have spread to Britain, Norway, Australia, Mexico, and
other countries that have newly developed natural resources.
The main premise of this fear is correct: Under many realistic conditions, the windfall of a new
natural resource does indeed erode profits and production in the manufactured goods sector.
Deindustrialization occurs for the same reason that underlies the Rybczynski theorem: The new
sector draws production resources away from the manufacturing sector. Specifically, to develop
output of the natural resource, the sector must hire labor away from the manufacturing sector,
and it must obtain capital that otherwise would have been invested in the manufacturing sector.
Thus, the manufacturing sector contracts.
Journalistic coverage of the link between natural resource development and deindustrialization
tends to discover the basic Rybczynski effect in a different way. The press tends to notice that
the development of the exportable natural resource causes the nation‘s currency to rise in value
on foreign exchange markets because of the increased demand for the country‘s currency as
foreign buyers pay for their purchases. A higher value of the nation‘s currency makes it harder
for its industrial firms to compete against foreign products whose price is now relatively lower.
To the manufacturing sector this feels like a drop in demand, and the sector contracts. The
foreign exchange market, in gravitating back toward the original balance of trade, is producing
the same result we would get from a barter trade model: If you export more of a good, you‘ll end
up either exporting less of another good or importing more.
Something has to give so that trade will return to the same balance as before. Even though the
Dutch disease does lead to some deindustrialization, it is not clear that this is really a national
problem. Merely shifting resources away from the manufacturing sector into the production of
natural resources is not necessarily bad, despite a rich folklore assuming that industrial expansion

is somehow key to prosperity. The country usually gains from developing production of its
natural resources, as long as this growth does not tip into the realm of the immiserizing.
DISCUSSION QUESTION
Why do many real-world examples of Dutch disease originate from developments in energy
products?
CASE STUDY
Americans have reason to worry about trends in real wages since the early 1970s. One major
trend has been a rising gap between the wages of relatively skilled workers and the wages of
less-skilled workers. For instance, from the mid- 1970s to the early 2010s, the ratio of the
average wage of college graduates to that of high school graduates increased by about 30
percent.
Many less-skilled workers have seen their wages decline in real (purchasing power) terms.
Meanwhile, the importance of international trade increased dramatically for the United States.
The ratio of the sum of exports and imports to total national production (GDP) close to tripled
from the early 1970s to the early 2010s.
Do we see here the effects on U.S. wages of a ―race to the bottom‖ driven by rising imports?
More precisely, is this the Stolper–Samuelson theorem at work, as rising trade alters the returns
to scarce and abundant factors in the United States?
Given the political implications of the trend toward greater wage inequality, economists have
studied it carefully. While increasing trade presumably has had some effect on wage rates
through the Stolper–Samuelson effect, economists have generally concluded that trade has not
been the main culprit.
For the Stolper–Samuelson theorem to be the main culprit—the predominant effect—at least two
other things should be true. First, the changes in factor prices should result from changes in
product prices. Specifically, a decline in the relative price of less-skilled-labor-intensive goods
should be behind the decline in the relative wages of less-skilled workers. Second, and more

subtly, the change in the relative wage should induce industries to become more intensive in their
use of the now cheaper less-skilled labor.
Neither of these two things appears to have occurred. Research on U.S. manufacturing industries
indicates that there is no clear trend in the relative international price of manufactured goods that
use less-skilled labor intensively. The data also show that most manufacturing industries became
more intensive in their use of skilled labor and less intensive in less-skilled labor.
The lack of change in the relative prices of traded goods and the rising skill intensity of
production are not consistent with the Stolper– Samuelson effect. The implication is that changes
in international trade prices are not the predominant cause of the rising wage inequality.
Other economists have concluded similarly that changes in the trade flows themselves (imports
and exports) are not the predominant cause. If not trade, then what? Most researchers have
concluded that the major driving force changing demands for skilled and unskilled labor has
been technological change. In fact, technological change may be pressuring relative wages in
two ways.
First, technological progress has been faster in industries that are more intensive in skilled labor.
As the cost and prices of some skill-intensive products decline, and the quality of these products
is improved, demand for the products increases. As demand shifts toward skill-intensive products
and their production increases, the demand for skilled labor expands, increasing the relative
wage of skilled labor.
Second, the technological progress that has occurred within individual industries appears to be
biased in favor of using more skilled labor. This bias increases demand for skilled labor even
more, reinforcing the pressure for an increase in wage inequality. We see this bias in the shift
toward greater use of computers generally and in the shift toward computer-controlled flexible
manufacturing systems in manufacturing specifically.
The United Kingdom has also experienced rising wage inequality between skilled and unskilled
workers, though the change is not as large as in the United States. In most other countries in
Western Europe and in Canada, these pressures seem to have played themselves out somewhat
differently.

Labor market institutions like high minimum wages have prevented wage rates for less-skilled
workers from declining so much. Instead, unemployment has increased since the early 1970s and
has remained high. While inequality of earnings has not increased so much in Canada and
WesternEurope, unemployment, especially among the less skilled, has become a serious
problem.
CASE STUDY
During the past 65 years, governments of industrialized countries reached a series of global
agreements that have reduced tariffs on their nonagricultural imports to very low levels. How did
they accomplish this remarkable reduction? And what is the position of the developing countries
in the process? To answer these questions, we take up the topic of global governance —practices
and institutions that condition how national governments interact with each other—with a focus
on international economic issues like trade.
GATT TO WTO
The story began during World War II, when the United States, Britain, and the other allies
started to discuss how to ensure that the economic system worked better after the war than it had
before the war. For trade, the goal was to find a way to avoid the virulent protectionism that had
taken hold in many countries in the early 1930s. The United States, Britain, and their allies
expected the key institution to be the International Trade Organization. However, it never came
into existence because of opposition, led by members of the U.S. Congress, to what many
viewed as the excessive breadth of the organization‘s proposed charter.
Instead, a ―provisional‖ accord, the General Agreement on Tariffs and Trade (GATT), became
the key institution. The GATT was signed in 1947 by 23 countries and focused squarely on
international trade issues. The number of countries in the GATT rose to 38 in 1960, 77 in 1970,
84 in 1980, and 99 in 1990. A new global agreement in the early 1990s led to the creation of the
World Trade Organization (WTO) in January 1995. The WTO, which subsumes and expands on
the GATT, is now the organization that oversees the global rules of government policies toward
international trade and provides the forum for negotiating global agreements to improve these
rules.

The WTO (like the GATT before it) espouses three major principles:
• Reductions of barriers to trade.
• Nondiscrimination, often called the mostfavored nation ( MFN) principle.
• No unfair encouragement for exports.
As of early 2014 the WTO had 159 member countries, including Russia, which joined in 2012.
In addition, 24 countries have been negotiating to become members. The WTO‘s headquarters
are in Geneva, Switzerland.
NEGOTIATIONS LOWER TARIFFS
In the first decades of its existence the GATT focused on tariffs. In recent decades other
(―nontariff‖) barriers have received more attention. Under the GATT, member countries pursued
eight rounds of multilateral trade negotiations to lower barriers. The first five rounds focused on
reductions in tariff rates, using item-by item negotiations in which the largest trading countries
agreed to mutual reductions and then extended these new lower tariffs to all members, following
the MFN nondiscrimination principle.
This meant that the negotiations were conducted among the largest industrial countries. In
addition, it was quickly recognized that lowering barriers to trade in agricultural products would
be fraught with controversy, so the negotiations focused on nonagricultural products.
The first round, Geneva 1947, achieved substantial tariff reductions (for instance, the average
U.S. tariff rate was reduced by 21 percent).
The next three rounds, Annecy 1949, Torquay 1950-1951, and Geneva 1956, achieved modest
new reductions, as did the Dillon Round (1960-1961), which also took up the creation of a
common external tariff schedule for the newly formed European Economic Community (now the
European Union).
To accomplish more substantial tariff reductions, the Kennedy Round (1963-1967) shifted the
process so that the industrialized countries began with an agreement to use a formula to lower all
nonagricultural tariffs and then negotiated limited exceptions in which some products had lesser

tariff cuts. This innovation worked—the average tariff reduction was 38 percent for
nonagricultural imports into industrialized countries.
The Tokyo Round (1973-1979) and the Uruguay Round (1986-1994) continued the process using
formulas for cuts, with negotiated exceptions Industrialized countries‘ nonagricultural tariffs fell
by an average of 33 and 38 percent, respectively.
DEVELOPING COUNTRIES
While the industrialized countries have negotiated tariff reductions, what has been the role of
developing countries? Of the 23 founding members of GATT, 13 were developing countries, and
now most WTO members are developing countries. However, until recently, developing
countries played little role in the multilateral trade negotiations. Because they were seldom major
exporters or importers of specific nonagricultural products, they were not active in the
negotiations of the first five rounds. In the Kennedy Round there was formal recognition that
developing countries did not need to offer tariff cuts even though they benefited from the tariff
reductions by the industrialized countries.
The Tokyo Round continued the approach, formalizing ―special and differential‖ treatment for
developing countries. In fact, most developing countries had not even agreed to maximum bound
tariffs for most products, so they were free to raise their tariffs if they wanted to.
While the developing countries benefited from the tariff reductions by industrialized countries,
they were not able to influence how the industrialized countries were lowering tariffs because
they were not involved in the give-and take of negotiating over mutual reductions.
Industrialized countries shied from lowering tariffs on ―sensitive‖ products, which were often the
labor-intensive nonagricultural products that were the most promising products for expanding
developing countries‘ manufactured exports.
In the 1980s many developing countries shifted toward a more outward-oriented strategy for
development . Many unilaterally lowered their tariff rates. They also became more involved in
the negotiations of the Uruguay Round, although ultimately the conclusion of the round still was
dominated by negotiations among the industrialized countries, especially the United States and
the European Union. As part of the Uruguay Round, many developing countries agreed to adopt

bound rates for most of their tariffs, though these bound rates often remain above their actual
rates. For example, Mexico has now bound most of its rates, but Mexico‘s average actual tariff
rate of 8 percent is well below its average bound rate of 36 percent.
RECENT PROGRESS
Under the WTO, reduction of tariff barriers continues. First, a special negotiation led to the
Information Technology Agreement of 1996. Each country adopting the agreement (initially 29
countries) commits to eliminate tariffs on imports of information technology goods (computers,
telecommunications equipment, semiconductors, semiconductor manufacturing equipment, and
related instruments and parts) and software. By 2014, 78 countries had adopted the agreement, so
that 97 percent of global trade in these information technology products is (or soon will be)
tariff-free.
Second, the developing countries that have joined the WTO since 1995 have generally lowered
their actual tariff rates as a condition for joining and accepted bound rates equal to or very close
to their actual rates. For instance, the average tariff rate of China, which joined the WTO in
2001, fell from 17 percent in 2000 to 11 percent in 2003. Third, reducing tariffs is an important
part of the agenda for the current Doha Round of trade negotiations.
Overall, the liberalization procedures set up under the GATT and continued under the WTO have
been remarkably successful in lowering industrialized countries‘ tariffs on nonagricultural
products. In part the multilateral negotiations have succeeded because each country‘s
government is able to defend its tariffcutting ―concessions‖ against the protests of domestic
protectionists as the price the country must pay to give its exporters better access to other
markets. This mercantilist logic is bad economics—we know instead that imports are something
the country gains and exports are something the country gives up—but the logic seems to be
useful politics.
Case Study
They Tax Exports, Too
Nearly all governments impose tariffs (taxes) on some imports into their countries. Most
governments do not impose additional taxes (duties) on their exports. Still, WTO rules allow

countries to impose export taxes. In the mid-2000s about half of WTO member countries did
have some duties on their exports. Typically, this is a developing country (e.g., Argentina,
Russia) imposing duties on its exports of one or more agricultural or other primary products.
Why would some countries impose extra taxes on their exports? What effects do export taxes
have? Let‘s start with the effects because understanding the effects provides clues to the reasons.
Consider a small exporting country, one whose supply of exports has essentially no effect on
world prices of its exports. The figure shows the country and the world price P0. If there is no
export tax, the country produces the quantity S0, consumes the quantity D0, and exports the
difference, S0 - D0. Now the country‘s government imposes an export tax equal to T dollars per
unit exported (a rate that reduces but is not high enough to completely eliminate exports of this
product).
What changes (and what does not change)?
For a small country, the world price P0 does not change. So, after the government collects the
tax, domestic producers receive revenue net of tax on their exports of only (P0 - T). These
producers will try to shift some sales to local consumers, who initially are willing to pay more.
But as competitive domestic producers strive to make more domestic sales, the domestic price is
also driven down to (P0 - T ). At the new price of (P0 - T ) received for both domestic sales and
exports, the country‘s quantity produced falls to S1, quantity consumed increases to D1,
and quantity exported decreases to (S1 - D1).
Well-being changes, for groups within the country and for the country overall. Consumers gain
surplus of area g + h, producers lose surplus of area g + h + j + k + n, the government gains
export tax revenue equal to area k, and the country suffers deadweight losses equal to areas j and
n. Area j is the inefficiency of domestic overconsumption of the product—the units from D0 to
D1 are worth less to domestic consumers than the P0 price that the country would receive from
foreign buyers if instead these units were exported. Area n is the inefficiency of national
underproduction of the product—the units from S1 to S0 cost the country less to produce than
the price P0 that foreign buyers would be willing to pay for them if they were produced and
exported.

As you can see, the effects of an export tax for a small country are analogous to the effects of an
import tariff for a small country.
What about a large exporting country that imposes an export tax? This case is also analogous,
and you may want to try to draw the graph yourself. The large exporting country has national
monopoly power in the world market. It can use an export tax to limit its export supply and drive
up the world price of the product. The country benefits from the higher world price for its export
product, and there is a nationally optimal export tax that could maximize its net gains from
enhancing its terms of trade in this way (assuming that the rest of the world is passive).
Why do we see some countries using export taxes (and other restrictions on exports)? The
analysis provides insights. First, the country‘s government may use export taxes, as it would use
any other tax, to raise revenue for the government. Second, the country‘s government may use
export taxes to benefit local consumers of the product. The local consumers could be households.
For example, in reaction to the increases in world food prices during 2007–2008, a number of
countries (including Thailand, Vietnam, and India) increased export taxes or otherwise restricted
exports of agricultural products like rice and sugar to keep local food prices low. Or the local
consumers could be firms in other industries that use this product as an input into their
production. The export tax artificially lowers their production costs and encourages the
expansion of these user industries. Third, for a large country, the country‘s government may be
using the export tax to gain national well-being at the expense of foreign buyers.
Are export taxes a good idea? For the first two reasons (more revenue or lower domestic prices),
the government is achieving some other objective at the cost of the deadweight losses. For the
third reason (exploiting national monopoly power), the country is risking retaliation by foreign
countries, and the export tax is reducing global efficiency.
DISCUSSION QUESTION
In March 2012 the Indian government prohibited the export of cotton. What are the possible
reasons for this export ban? Which one or two seem to be the most plausible reasons?

The World Trade Organization (WTO), which in 1995 subsumed the General Agreementon
Tariffs and Trade (GATT). That box documentedthe success of the rounds of multilateral
tradenegotiations in reducing the tariffs imposed byindustrialized countries on most
nonagriculturalgoods.
We now turn to examine three ways inwhich the WTO tries to go beyond tariffs on
nonagriculturalgoods:
• As tariffs have declined, the use of nontariffimport barriers has increased. How have theWTO
and the GATT tried to limit and reducenontariff barriers?
• The birth of the WTO in 1995 coincided withefforts to push trade rules and trade
liberalizationinto new areas. What are these newareas, and what are the agreements?• The
current round of trade negotiations, theDoha Round, is an ambitious effort to push further,but as
of late 2014 there had been modestprogress.
What are the key objectives of theDoha Round, and why the lack of progress?
NONTARIFF BARRIERS
The original GATT of 1947 included provisionsthat limited countries‘ use of some barriers
toimports other than tariffs. Most important was aprohibition on the use of import quotas on
nonagriculturalgoods. Countries complied by removingsuch quotas—another major success for
theGATT.
The agreement also stated that any governmentalrules and regulations should not
discriminateagainst imports; imports and domesticproducts should be treated equally, often
called―national treatment.‖ In addition, the agreementincluded provisions for national
governments totake actions against foreign dumping using antidumpingmeasures and against
export subsidiesusing countervailing measures.
As tariffs declined and NTBs (other thanquotas) rose in importance, the GATT membersbegan to
discuss NTBs more seriously. Yet, negotiationshave had less success in reducing NTBs.The
protective effects of NTBs are harder to measure,so it is harder to get negotiated agreementon
what constitutes an international exchange of―comparable‖ NTB reductions.

The Kennedy Round (1963–1967) included someNTB negotiations but the results were slim—
onevoluntary code on dumping and antidumpingprocedures. The Tokyo Round (1973–1979)
madesome progress and resulted in six voluntary codeson NTBs, covering customs valuation,
import licensingprocedures, government procurement, productstandards and similar technical
barriers, subsidiesand countervailing measures, and dumping andantidumping measures.
However, the codes had only modest effects in limiting or reducing NTBs.
The Uruguay Round (1986–1994) was more ambitious. The agreements from this round created
the WTO, addressed a number of NTBs, and required that all countries joining the new WTO
accept nearly all the NTB agreements.
The Uruguay Round agreements also gave the newWTO a much stronger process for resolving
disputesbetween countries about NTB and othertrade issues. The Uruguay Round agreements on
NTBs arefar-ranging and include new or revised codeson customs valuation, import licensing,
importprocedures, safeguards (temporary increasedprotection against import surges), subsidies,
anddumping. Codes on technical standards establishedtwo rules to reduce the use of standardsas
subtle NTBs. Standards and regulations shouldnot restrict imports more than the minimum
necessary to achieve their legitimate objectives,and standards about food safety should be
basedon scientific evidence.
Another major outcome was that governments agreed to phase outthe global web of voluntary
export restraintson textiles and clothing. In addition, governments agreed to end the use of most
other VERs, and they agreed to limit their use of domestic content requirements.
NEW AREAS
The Uruguay Round agreement established WTOrules to cover three areas that had
receivedalmost no attention in previous rounds. First, thetreatment of agricultural goods was
shifted tobe similar to that of industrial goods. Tariffs (andtariff-rate quotas) have replaced many
agriculturalimport quotas and other NTBs. In addition, governments agreed to limits on their
domestic subsidies to agricultural production and to some reductions of their export subsidies for
agricultural products.

Overall, the effects of thesechanges have been modest. For instance, the newtariffs were usually
set high enough that therehas been little increase in total trade.Second, the agreement on ―trade-
relatedintellectual property‖ created global rulesrequiring protections of patents, copyrights,
andtrademarks. The purpose is to get all governments behind efforts to prevent counterfeiting of
branded products and pirating of technology, software, music, and films.
Third, the Uruguay Round established a newset of rules, the General Agreement on Trade
inServices. Many countries limit international tradein services with legal red tape or with
outright bans on foreign providers.
This new agreement provides a framework for efforts to liberalizetrade in services, although it
contained little in theway of actual liberalizations. Subsequently, therewas some progress. In
1997, 69 countries reached an agreement to open up national markets for basic
telecommunications services, and 70 countries reached an agreement to remove restrictions in
banking, financial services, and insurance.
THE DOHA ROUND
The effort to launch a new round of multilateraltrade negotiations in the late 1990s was
turbulentin two ways.
First, the WTO, with its broadermandate, became a focal point for protestsagainst globalization.
Second, the governments of the member countries had difficulty agreeing on what the new round
should accomplish, a challenge, because decision making in the WTO is generally by consensus.
Since the late 1990s protests have swirled around meetings of the WTO and other international
organizations.
Many groups have been involved, including human-rights activists, environmentalists,

consumer-rights advocates, organized labor (unions), anti-immigration groups, animal-rights
activists, and anarchists. It is not easy to summarize their positions toward the WTO, but
prominent complaints and demands, some of them contradictory with others, have included:
• That the WTO is too powerful, undemocratic, and secretive and should be abolished or greatly
reined in.

• That the WTO should expand the use of its powers to achieve goals other than free trade,
especially such goals as environmental protectionand better wages and working conditions in
developing countries.
• That the WTO is the tool of big business andthat freer trade benefits corporations andcapitalists
while hurting the environment,local cultures, and workers.After failing to begin the new round at
theWTO ministerial conference in Seattle in 1999,the next conference was in Doha, Qatar, in
2001.Developing countries believed that they had notreceived a fair deal in the Uruguay Round.
Theyincurred substantial costs by accepting the mandatory NTB rules and the mandatory
protections of intellectual property, but their benefits of greateraccess to export markets in the
industrialized countrieswere limited by the slow end to the VERs onclothing and textiles and by
the lack of actual liberalizationof agricultural trade.
Developing countrygovernments pushed for a ―development round‖and vowed to be more active

in the negotiations.After much wrangling at the 2001 meeting,the ministers agreed on the agenda
and launched the Doha Round of trade negotiations.Each of the major players (the United States,
theEuropean Union, and the developing countries)compromised to reach the consensus.
Key elementsof the ambitious agenda include substantialliberalization of agricultural trade,

reductionsof tariffs on nonagricultural goods, liberalizationof trade in services, provision of
assured accessby developing countries to low-cost medicinesto protect public health, and
refinement of rulesgoverning various NTBs. (In a separate agreementreached in 2003,
developing countriesgained the right to import cheap generic versionsof patented drugs in health
emergencies.)
The Doha Round negotiations have beenintermittent and mostly unproductive for morethan a
decade. A meeting in July 2008 seemedto make progress but collapsed when some developing
countries, led by India and China, demanded a ―safeguard‖ process that wouldallow them to
easily increase tariffs on importsof agricultural products if and when such imports increased.In
December 2013 the WTO members reacheda multilateral trade agreement about trade
facilitation, a small part of the Doha agenda.Countries agreed to lower costs and to acceptbinding
standards for customs and border procedures.

Most of the benefits from the agreementwill go to developing countries. However, in mid-2014
India blocked the process to adopt the agreement.Discussions about other aspects of the Doha
agenda have continued, but progress hasremained elusive. The United States has resisted
meaningful cuts in its agricultural subsidies. TheEuropean Union has sought to limit lowering
itsbarriers to agricultural imports. India, Brazil, andother developing countries have been
unwilling to reduce tariffs and to open up service sectors.
CASE STUDY
Global Crisis Dodging Protectionism
If this bill is enacted into law, we will have arenewed era of prosperity . . .
Representative Willis Hawley, Republican of Oregon, June 1930
The global crisis that began in 2007 was theworst global economic crisis since the Great
Depression of the 1930s. Protectionism played akey role in the Great Depression, but
fortunatelyhistory did not repeat itself.As the Great Depression began in 1929, theU.S. Congress
was debating a bill to increase U.S. tariffs. The notorious Smoot-Hawley tariffbill was passed in
June 1930.
By itself, its tariffincreases were not that large, adding severalpercentage points to average U.S.
tariffs. Butit did not lead to prosperity. Rather, other countries retaliated against the United
Statesby enacting similar tariff increases. The averageworld tariff rose from 9 percent in 1929
to20 percent in 1933. By 1933 world trade had fallen to only one-third its 1929 level.
While much of this decline was the decrease in trade that accompanies macroeconomic
reductionsin national production and income levels, atleast one-quarter of the decline was due
tothe rapid rise in protectionism around theworld. Protectionism did not cause the Great
Depression, but it did make it longer and worse than it otherwise would have been.As the global
crisis of the 2000s deepened,some countries again resorted to forms of protectionism.What
happened, and how did we avoida repeat of the 1930s?
There were no widespread increases in tariffs although a few countries, Russia, Argentina, and
Turkey, did increase tariffs by an average of about one percentage point. Overall, global tariff

increases explain very little of the trade decline. A number of countries increased nontariff
barriers to trade:
• Some imposed tougher import licensing; forexample, Argentina shifted to discretionary

licensing for imports of car parts, televisions, shoes, and some other items.
• Some enacted more complicated customs procedures; for example, Indonesia limited imports of
clothes, shoes, toys, and some othergoods to only five ports of entry.
• Some adopted new product standards thatblocked some imports; for example, Chinaagainst
certain European foods and beveragesand India against Chinese toys.
• Some placed new ―buy domestic‖ requirementson government spending as part of fiscal
stimulusefforts; for example, new ―Buy American‖rules in the U.S. stimulus bill passed in
2009.Still, overall the new protectionist measures weremodest. The WTO estimated that less
than 1 percentof world trade was affected.Three forces were at work to limit increasesin import
barriers. First, world leaders did notwant to repeat the experience of the 1930s.
Forexample, in November 2008, at the meeting ofthe Group of 20 (G-20) major countries,
leadersof these countries formally declared that theycommitted to ―refrain from raising new
barriersto investment or to trade in goods and services.‖Second, the WTO as a strong multilateral
organization reinforced the resolve, through its agreedprinciples and rules and through its
monitoringand reporting of trade policy developments.Third, in many countries the government
policyresponse was focused more on bailouts (forexample, financial institutions) and subsidies to
domestic firms (for example, auto producers)than on directly limiting imports. Such subsidiescan
distort trade, but the subsidies did not leadto widespread policy retaliation or destruction oftrade.
Fortunately for the world, after the minitradecollapse of late 2008 and 2009, world trade bounced
back.
CASE STUDY
The analysis of an import quota presented in thetext presumes that the domestic industry in
theimporting country is highly competitive. Withperfect competition we saw that the effect ofthe

quota on domestic producer surplus is thesame as the effect of a tariff that results in thesame
quantity of imports. In this case, the domestic industry would not have a strong preference
between the quota and the equivalent tariff. Domestic industries are often highly competitive, but
not always.
Especially for a smallcountry, in some industries no more than one ortwo domestic firms can
achieve scale economiesin production if they are selling only to local consumers. This would be
true for industries like automobiles or steel. If the domestic industry is a monopoly, would the
monopoly have a preference between a tariff and a quota? The answer is yes.
The monopoly prefers the quota (even if the monopoly does not get any of the price markup on
the imports themselves).Let‘s look at this more closely. (We assume that the importing country is
a small country, but the same idea holds for the large-country case.)The domestic monopoly
would like to use its market power to set the domestic price to maximize its profits. But with free
trade the world price becomes the domestic price.
Imports entering the country at the world price prevent the domestic monopoly from charging a
higher price than the world price. If it did try to charge a higher price, most consumers would
just buy imports. Free trade is a good substitute for national antitrust or anti monopoly policy.If
the country‘s government imposes a tariff, the domestic price rises to be the world price plus the
tariff. The pricing power of the monopoly is still severely limited.
If the monopoly tries to charge more than this tariff-inclusive price, again most consumers would
just buyimports. Domestic consumers can buy as muchof the imported product as they wish, as
long asthey are willing to pay the tariff-inclusive price.They will not pay more for the locally
producedproduct.If instead the country‘s government imposes a quota, the whole game changes.
No matter how high the monopoly raises its domestic price, imports cannot exceed the quota
quantity.Domestic consumers cannot just shift toimports because there is a strict limit on how
much they can import. The marginal source of more of the product is now the
domesticmonopoly.
After allowing for the quota quantityof imports, the domestic monopoly can setthe domestic
price to maximize its profits. Incomparison to a tariff that results in the samequantity of imports,
the domestic monopolyprefers an import quota because the monopolycan set a higher price and

garner larger profits.However, these higher profits come at a cost tothe importing country as a
whole. If the domesticindustry is a monopoly, the quota causes alarger net national loss.A pair of
graphs for the domestic monopolycan highlight the differences between the tariffand the quota.
The figure on the previouspage shows the case of the tariff.
With free trade at the world price P0, the monopolist cannot charge a price higher than P 0, so
the monopoly produces all units for which its marginal costs are less than this free-trade price.
The tariff raises the domestic price to P1, but the monopolist cannot charge a higher price than
this tariff-inclusive price.
The monopolist increases production from S 0 to S 1 and increases its profits by area a. Imports
with the tariff are M1. The net loss in national well-being becauseof the tariff equals area b +
d.The figure below shows what happens if this same M 1 quantity of imports is instead set as a
quota.
With the fixed quota quantity of imports, the monopoly views its market as domestic demand
less this quota quantity (for all prices above the world price P0). That is, the monopoly faces the
downward-sloping net demand curve (the domestic demand curve minus the quota quantity).
Using the net demand curve, the monopoly can determine the marginal revenue from lowering
price to sell additional units.
The monopoly maximizes profit when marginal revenueequals marginal cost, producing and
selling quantity S 2 and charging price P 2 .In comparison with the tariff, the monopoly uses the
quota to increase the product price ( P 2> P 1 ), to reduce the quantity that it producesand sells (
S 2 < S 1 ), and to increase its profit. The monopoly prefers the quota, but the monopoly‘s gain
comes with some additional social cost.In comparison with the tariff, the economicinefficiency
of the quota is larger. The nationas a whole loses not only area b + d but alsothe shaded area. The
shaded area is the additional social loss from unleashing the monopoly‘spower to restrict
production and raise prices.Additional consumers are squeezed out of themarket, and they suffer
an additional loss ofconsumer surplus that is not a gain for any othergroup.We can combine this
conclusion with the conclusionsreached in the text. For the nation asa whole, at best the quota is
no worse than anequivalent tariff as a way of impeding imports. Theimport quota is worse than
the tariff in two cases:

• If quota licenses are allocated throughresource-using application and selectionprocedures.
• If a dominant domestic firm can use the quotato assert its monopoly pricing power

Case Study Case Study
VERs: Two ExamplesVoluntary export restraints provide for rich interplaybetween economics
and politics. Let‘s look attwo examples. In the first, the United States forcedone key exporter,
Japan, to limit its exports of automobiles.In the second, a small VER, again betweenthe United
States and Japan, grew to become awide-ranging set of export limits that coveredmany textile
and clothing products, involved manycountries, and lasted for decades.
AUTO VER: PROTECTION WITHINTEGRITY?
Before the mid-1970s import totals of automobilesinto the United States were minuscule. Then,
in the late 1970s, sales of Japanese-made automobiles accelerated in the United States. American
buyers were looking for smaller cars in the wakeof substantial increases in the price of oil.
Japanese manufacturers offered good-quality smaller carsat attractive prices.
Japanese cars were capturing a rapidly growing share of the U.S. auto market, U.S. production
of cars was declining, American autoworkers were losing their jobs, and the U.S. auto companies
were running low on profits.

In early 1981 the protectionist-pressure tachometer was in the red zone. Japanese auto exports
were caught in the headlights, with Congress ready to impose strict import quotas if
necessary.Ronald Reagan, the new U.S. president, had a problem. In March 1981, his cabinet
was discussing auto import quotas.
Reagan‘s autobiographylater explained his thinking at that moment: As I listened to the debate, I
wondered if theremight be a way in which we could maintain theintegrity of our position in favor
of free tradewhile at the same time doing something to helpDetroit and ease the plight of
thousands oflaid-off assembly workers . . .I asked if anyone had any suggestions forstriking a
balance between the two positions.[Then–Vice President] George Bush spoke up:―We‘re all for
free enterprise, but would any ofus find fault if Japan announced without anyrequest from us that
they were going to voluntarilyreduce their exports of autos to America?‖
*A few days later Reagan met with the Japaneseforeign minister.Foreign Minister Ito . . . was
broughtinto the Oval Office for a brief meeting . . .I told him that our Republican
administrationfirmly opposed import quotas but that strongsentiment was building in Congress
amongDemocrats to impose them.―I don‘t know whether I‘ll be able to stopthem,‖ I said. ―But I
think if you voluntarily set a limit on your automobile exports to the country, it would probably
head off the bills pending in Congress and there wouldn‘t be any mandatory quotas.‖
*The Japanese government got the messageand ―voluntarily‖ agreed to make sure thatJapanese
firms put the brakes on their exportsto the United States.
Maximum Japanese exportsto the United States for each of the years 1981through 1983 were set
at a quantity of 1.8 millionvehicles per year, about 8 percent less than whatthey had exported in
1980. As total automobilesales in the United States increased substantiallyafter the 1981–1982
recession, the export limitwas raised in 1984 to 2 million and in 1985to 2.3 million. The export
restraint continuedto exist until 1994, but from 1987 on actualJapanese exports to the United
States were lessthan the quota quantity. By 1987 Japanese firmswere producing large numbers of
cars in factoriesthat they had recently built in the United States.As a result of the VER, the
profits of U.S. autocompanies increased, as did production andemployment in U.S. auto
factories.

What did theVER cost the United States? One study estimatedthat the VER cost U.S. consumers
$13 billion inlost consumer surplus and that it imposed a netloss to the United States of $3
billion. Other estimatesof these costs are even higher. ―Protectionwith integrity‖ does not come
cheap.
TEXTILES AND CLOTHING: A MONSTER
In 1955, a monster was born. In the face of rising imports from Japan, the U.S. government
convincedthe Japanese government to ―voluntarily‖ limit Japan‘s exports of cotton fabric and
clothing to theUnited States. In the late 1950s, Britain followedby compelling India and Pakistan
to impose VERson their clothing and textile exports to Britain.The VERs were initially justified
as ―temporary‖restraints in response to protectionist pleas fromimport-competing firms that they
needed time toadjust to rising foreign competition. But the monsterkept growing.The 1961 Short-
Term Arrangement led tothe 1962 Long-Term Arrangement. In 1974, the Multifibre
Arrangement extended the scheme toinclude most types of textiles and clothing. Thetrade policy
monster became huge. A large andrising number of VERs, negotiated country bycountry and
product by product, limited exportsby developing countries to industrialized countries(and to a
number of other developing countries).The monster even had its own growth dynamic.
A VER is, in effect, a cartel among the exportingfirms. As they raise their prices, the
profitopportunity attracts other, initially unconstrainedsuppliers. Production of textiles and
clothing for export spread to countries such as Bangladesh, Cambodia, Fiji, and Turkmenistan.
As these countries became successful exporters, the importing countries pressured them to enact
VERs to limit their disruption to the managed trade.The developing countries that were
constrained by these VERs pushed hard during the Uruguay Round of trade negotiations to bring
this trade back within the normal WTO rules (no quantitative limits, and any tariffs to apply
equally to all countries—most favored nation treatment, rather than bilateral restrictions).
The Agreement on Textiles and Clothing came into force in 1995 and provided for a 10-year
period during which all quotas in this sector would be ended. On January 1, 2005, after almost a
half century of life, the monster mostly died.We say ―mostly‖ because for a few more years a
small piece of the monster lived on. As part of its accession agreement to the WorldTrade

Organization, China accepted that other countries could impose China-specific ―safeguards‖ if its
rising exports of textiles or clothing harmed import-competing producers.
As the United States phased out VERs, the U.S.government imposed such safeguards on some
imports from China. By late 2005 a comprehensive agreement limited imports of 22 types of
products from China. Similarly, the European Union imposed safeguard limits on imports from
China on 10 types of products. Then, the monster finally took its last breaths. The EU limits
expired at the end of 2007 and the U.S.limits expired at the end of 2008. (Still, we donot have
free trade in textiles and clothing because many countries continue to have relatively high import
tariffs in this sector. But the web of VERs has ended.) Consumers are the big winners from the
liberalization. Prices generally fell by 10 to 40 percent when the VERs ended. Another set of
winners is countries, including China, India, and Bangladesh, that have strong comparative
advantage in textiles and clothing but whose production and exports had been severely
constrained by the VERs.
On the other side, with rising imports, textile and clothing firms and workers in the United States
and other industrialized countries have been harmed. Another set of losers is those developing
countries, apparently including Korea and Taiwan, that do not have comparative advantage in
textile and clothing production but that had become producers and exporters of textiles and
clothing because the VERs had severely restricted the truly competitive countries. (This shows
another type of global production inefficiency that resulted from the VERs.) These
uncompetitive countries lost theVER rents that they had been receiving, and their industries
shrank as those in countries such as China expanded.
DISCUSSION QUESTION
In late 1981, a person went to a Honda dealer in his home state and paid about $1,000 more for a
Civic than he would have paid the year before.Why?
Carrots Are Fruit, Snails Are Fish, and X-MenAre Not Humans
Governments have shown perhaps their greatest trade-policy creativity when deciding in what
categories different imported goods belong. Their decisions are by no means academic. The
stakes are high because an import that falls into one category can be allowed into the country

duty free, whereas the same import defined as falling into a related category is subject to a high
tariff or banned altogether.
You can bet that if definitions matter so much to trade policy, there will be intense lobbying over
each product‘s official definition.Protectionists will insist that an imported product be defined as
belonging to the category with the high import barrier, but importing firms will demand that it be
put in the duty-free category.When such strong pressures are brought on government,don‘t
always expect logic in the official definitions.
Some of the resulting rules are bizarre. For example, here are two included in regulations passed
by the European Union (EU) in 1994:
• Carrots are a fruit. This definition allows Portugal to sell its carrot jam throughout Western
Europe without high duties.
• The land snail, famously served in French restaurants,is a fish. Therefore, European snail
farmers can collect fish farm subsidies.The U.S. government has similarly bent the rules.
In the early 1990s Carla Hills, then the U.S.trade representative, was compelled to call the same
car both American and ―not American.‖She told the Japanese government that car exports from
U.S. factories owned by Japanese firms to Japan were Japanese, not American.They did not
count when the U.S. government examined the size of American car exports to Japan.
At the same time, she told European governments that the cars exported to Europe from these
same Japanese-owned factories in the United States were American, so they were not subject to
European quotas on Japanese car imports.With even greater ingenuity private firms have
changed the look and the names of their products to try to get around each set of official
definitions.
For instance, a VER on down-filled ski parkas led to the innovation of two new products that
were not subject to VERs. One product was a down-filled ski vest that had one side of a
Zipperon each armhole. The other product was a matched pair of sleeves, with one side of a
zipper at the top of each sleeve. Once the two products were imported ―separately,‖ the
distributor knew what to do.As another example, Subaru once imported pickup trucks with two

flimsy ―rear seats‖ bolted to the truck bed to avoid the U.S. tariff of25 percent on ―regular‖
pickup trucks.
To avoid the same 25 percent U.S. duty, Ford imports vans from Turkey as ―passenger wagons‖
because the vans have both rear side windows and rear seats.Once past customs Ford removes
and trashes the rear windows and seats, replaces the windows with metal panels, and sells them
as small commercial delivery vans.In some cases it is a U.S. judge that makes the call. In 2001, a
judge ruled that cheap children‘sHalloween costumes (think Scream) were―fancy dress apparel,‖
not the ―flimsy festive articles‖ that the U.S. Customs Service had long considered them. The
suit was a victory for the U.S. producer, Rubie‘s Costume Company, that brought it.
Rather than entering duty-free,imported costumes (that competed with Rubie‘s)would be subject
to a tariff up to 32 percent and be covered by the VERs on clothing. Trick or treat?
In 2003, another U.S. judge studied opposing legal briefs and more than 60 action figures,both
heroes and villains. Among her conclusions were that the X-Men were not humans, nor were
many of the others. She was not just playing around: Toys that depict humans are dolls subject to
12 percent import tariffs, but toys that depict non humans are just toys, subject to 7 percent tariff.
Such games have been played with great frequency over the definitions of products. As long as
definitions mean money gained or lost, products will be defined in funny ways.
DISCUSSION QUESTION
During your foreign travel in South Asia, you acquired an expensive, elaborately woven
textile,size 1 meter by 2 meters. At customs as you are returning home, the official asks if it is a
rug or a decorative wall hanging. What do you reply?
CASE STUDY
After 15 years of complex and sometimes difficult negotiations, China became a member of the
WTO in late 2001. To become a member,a country must gain acceptance from all WTOmembers
(an example of WTO decision making by consensus).

In this process, China agreed to make major changes in many of its trade policies and other
economic policies—in some ways the commitments go well beyond those of members who
joined many years ago.Has China gained what it hoped from its membership in the WTO?
Broadly, China has obtained substantial benefits from freer trade. China's trade continues to
grow rapidly, as does its economy. China has gained the general benefits of WTO membership.
China now has MFN treatment by other members.
It has gained a seat atWTO-sponsored multilateral trade negotiations,although its role in the
Doha Round negotiations was low-keyed until 2008.As a WTO member, China qualified for the
end of the VERs that limited its exports of clothing and textiles.
When the VERs were removed, China's exports were limited for a few more years by safeguards
imposed by the United States and theEuropean Union. Still, its export of these products has
grown rapidly during the past decade.China‘s entry into the WTO has continued its integration
into the global economy, and it became more attractive as a destination for direct investments by
foreign firms.
In turn,the operations of foreign firms in China have spurred its trade and economic growth. In
addition,the WTO commitments have been useful in domestic politics, by strengthening the
positions of reformers within the Chinese government leadership.In pursuit of these economic
benefits, what commitments did China make to join the WTO,and how has it been doing in
meeting these commitments?Here are some major areas covered by the accession agreement.
• Tariff reductions: China had been reducing its tariff rates prior to joining the WTO, and it
continued to do so. For industrial products, the average tariff rate has declined to 9 percent from
14 percent in 2001. Some reductions are dramatic.
The tariff on autos declined from 80 percent to 25 percent, and tariffs on

computers,telecommunications equipment, and other information technology products were
eliminated. For agricultural products, China has dropped its average tariff to 16 percent from 23
percent in 2001. All tariff rates a rebound (so that China cannot arbitrarily increase them in the
future).

• Services: China agreed to a range of commitments under the General Agreement on Trade in
Services to provide better market access for foreign services firms. For instance,China has
removed or liberalized limits on the local activities of foreign firms engaged in banking,
financial services, and insurance. Still,foreign firms have expressed some concerns that other
rules and regulations have been used to limit their ability to benefit from the changes.
High capital requirements have been imposed on foreign-owned banks and the process of
gaining approvals for new office locations and for additional products has been costly and slow.
Another concern is thatChina has failed to implement a process for approving the entry of
foreign firms providing computer travel reservation services.
• Intellectual property: China agreed to bring its laws protecting intellectual property
rights(patents, brand names and trademarks, and copyright) into conformity with WTO and other
international standards and to enforce these laws. China‘s laws are generally in
conformity.However, there remain major concerns that piracy and product counterfeiting are
rampant and that the laws are not enforced.Overall, China has made major changes,including
amending several thousand laws and regulations.
China generally has met the commitments that it made to join the WTO, though in some areas it
has been slow or has taken other actions that offset some of its liberalizations.By joining the
WTO, China also became part of the WTO‘s dispute settlement system.
After a slow start, China is now fully enmeshed in the system.Before 2007, China filed only one
complaint and was the respondent to only four complaints from other countries (and three of
these were about the same matter).
Since 2007, China has lodged the third-largest number of complaints(behind the United States
and the EU), and it has been the alleged violator more than any other WTO member.From 2002
to early 2014, China filed 12 complaints in total, with the United States or the EUthe respondent
in all of them.
In all but one of these cases, China alleged that the respondent had misused or misapplied anti
dumping duties,countervailing duties, or safeguards, types of contingent protection. Most of

these cases led to decisions by panels after the countries could not reach agreements by
consultation.
Most panel decisions found that the United States or the EU had violated WTO rules, and they
then implemented changes. For example, in the one case that did not involve contingent
protection, in 2009 China complained that the United States had not followedWTO rules when it
banned imports ofChinese poultry.
After the panel ruled in favor of China‘s complaint, the United States removed the ban.From the
first case in 2004 to early 2014, China was the respondent in 31 cases that involved19 distinct
matters. In all the matters except one,the complainants included the United States or the EU
(sometimes both). For three matters,consultations led to mutually agreed solutions in which
China changed its policies. Five matters had not (yet) progressed past consultations, and the
other 11 matters went to panels. Six panel decisions found that China had violated WTO
rules,and China then made changes to bring itself into conformity.
As of early 2014, there were only two matters in which China had lost panel decisions but had
not implemented changes within a reasonable time, and in one of these China seemed to be
moving slowly to make changes.Here are a few of the cases with China as the respondent. In
2004, the United States filed the first WTO case against China, alleging that China was using
discriminatory domestic tax rates to favor integrated circuits that were designed or made in
China. Negotiations led to a resolution in which China ended the tax differential.The first
complaints against China to go to a panel were filed in 2006 by the EU, theUnited States, and
Canada, alleging that China was imposing tariffs on automobile parts that exceeded China‘s
bound rate, through a form of domestic content requirement. In early 2008 the panel hearing the
case ruled that the Chinese policy violated WTO rules, and China then changed its policies.
In 2010, the United States, the EU, and Mexico complained that China‘s limits on exports of
certain raw materials provided unfair advantages toChinese producers that used these raw
materials as inputs. After the panel ruled against China,China removed its restrictions.
In 2012 the UnitedStates, the EU, and Japan filed similar complaints that China was restricting
exports of rare earths.In 2014, the WTO panel again ruled that China had violated WTO rules
and commitments with its export restrictions.China‘s role as a major player in the WTOdispute

settlement system shows the value of the WTO processes. China has a legitimate way to address
and attempt to resolve trade conflicts with two of its largest trade partners, the United States and
the EU. In most dispute cases in which one of these countries is using procedures or enacting
policies that do not conform to WTOrules and commitments, the country has eventually
amended its procedures and policies to bring them in line with WTO rules.
CASE STUDY
Defenders of protection against imports claim that it is needed to protect domestic jobs.
Although it sometimes sounds like any people who lose their jobs to increased imports are
unemployed forever,we know that is not true.
Workers lose their jobs for many reasons, and nearly all of them then look for and find other
jobs. It may take a while and the new jobs may not pay as much (at first) as the previous jobs
did, but they will be reemployed.So the proponents of protection are really saying that
restrictions on imports are needed to maintain jobs in the import-competing industry that is
receiving the protection.
We know that import barriers can maintain jobs in an import competing industry by permitting
domestic production at a level higher than it would be with free trade. But we also know from
the discussion in the text that the specificity rule shows that an import barrier is not the best
government policy to accomplish this objective.
Still, governments do use tariffs and non tariff barriers to prop up domestic production and
maintain jobs in import-competing industries.How large are the costs of doing so? We can
examine the costs in two ways. First, how much does it cost domestic consumers of the product
per job maintained? That is, what is the consumer surplus loss per job maintained?
Second, what is the net cost to the country per job maintained?We can turn to researchers at the
Institute ofInternational Economics to provide some estimates.Hufbauer and Elliott (1994)
examined 21 highly protected industries in the United States,and Messerlin (2001) examined 22
highly protected industries in the European Union, both for 1990. Their estimates assume that the
tariffs and import quotas do not affect world prices, the small-country assumption. Here is what
they found:

CASE STUDY
For the 21 industries in the United States,the jobs maintained by import protection represented
about 10 percent of workers in these industries and less than 0.2 percent of the U.S.labor force.
For the European Union, the maintained jobs were about 3 percent of workers in the 22
industries and less than 0.2 percent of the labor force.
These estimates show the high cost of maintaining industry jobs through high levels of import
protection. For the United States, consumers paid an average of about $169,000 per job
maintained, and in Europe about $191,000per job.
Per year, this was over six times the average annual compensation for a manufacturing worker in
each country. It would have been much cheaper for domestic consumers to simply pay these

workers not to work than it was to maintain their jobs using import protection.For some specific
industries the consumer cost per job maintained in the industry is breathtaking:
• For the United States, $600,000 for a sugar job and $498,000 for a dairy products job.
• For the European Union, $512,000 for an autoworker job and $474,000 for a chemical fiber
job.The net national cost per job was also high in both countries: $54,000 in the United States
and$99,000 in the European Union.
The net national cost per job was higher than the compensation earned by the typical
manufacturing worker. It is worth noting that the average net national costs per job were this
high because some of the protection was through VERs and similar policies that permit foreign
exporters to raise their prices.
Even if we remove these price markups lost to foreign exporters, the net national cost per job
was still rather large—an average $18,000 in the United States and $42,000 in the
EuropeanUnion.
If our goal is to maintain jobs in these industries,the specificity rule says we can do better.Just
paying the workers to have jobs in which they do nothing would be less costly.
Indeed, the cost per person of a high-quality worker adjustment program that offers training and
assistance to these workers to find well-paying jobs in other industries would be much less than
the net national cost of maintaining these jobs through high import barriers.
CASE STUDY
Do you like to eat things that are sweet? If you do,and if you live in the United States, the
EuropeanUnion, or Japan, then you are a victim of your country's protectionist policies toward
sugar. The domestic price of your sugar is about double the world price. For the United States,
on average during 2000–2013, the domestic price of raw sugar was $0.24 per pound, while the
world price was$0.14 per pound. For the United States, sugar protection costs consumers about
$3.5 billion per year.If you live in any of these countries, have you ever sent a letter to your
legislative representative asking him or her to oppose sugar protection,a policy that is clearly
against your interests? Have you contributed money or time to a group that lobbies the

government to end sugar protection?Do you know anyone who has ever done so?Presumably
not. Why not? While $3.5 billion per year sounds like a lot of money, it is only about$11 per
person per year. As discussed in the text,the average gain for any one person to oppose this
protection is small. It‘s not worth your effort.The situation is a little different for sugar
producers.For the United States, the increase in domestic producer surplus is about $1.5 billion
per year. These gains are concentrated in a small number of firms.It is worth it for them to
actively seek policies that restrain sugar imports. Two companies, AmericanCrystal in North
Dakota and Minnesota, and Flo-Sunin Florida, have been particularly active, contributing
millions of dollars in recent years to Democratic and Republican congressional candidates and
political parties. For Flo-Sun, owned by two brothers,Alfonso and Jose Fanjul, one estimate is
that protectionist sugar policies add $65 million per year to their profits. A few million bucks to
defend this profit stream is definitely a good investment.Another group active in lobbying is
theAmerican Sugar Alliance, representing major U.S.sugar growers. In addition, the high
domestic price for sugar expands demand for corn sweeteners,a close substitute for sugar. Corn
farmers in the American Midwest like the sugar protection,and they have a major influence on
the positions taken by their states‘ representatives and senators.The Coalition for Sugar Reform,
which includes food manufacturers that use sugar, consumer groups, taxpayer advocates, and
environmental groups, is active in opposing sugar protection. It has some good arguments on its
side. As Jeff Nedelman,a spokesperson for the coalition, said, ―This is a corporate welfare
program for the very rich.‖ * The coalition points out that jobs are being lost as sugar using firms
shift production to other countries where sugar prices are cheaper. Furthermore, by polluting and
disrupting water flows, the protected sugar production in Florida is also a cause of serious
environmental decline in the Everglades. These are good points, but they are no match for the
money and organization of the proponents of protection.Foreign sugar producers, many of them
poor farmers in developing countries, are also hurt by protectionist policies in importing
countries.Researchers estimate that the world sugar price would rise by 17 percent if the United
States removed its sugar policies. But it is not easy for foreign interests to have an effect on the
U.S.political process. Foreigners don‘t vote, and political opponents can charge that legislators
who openly side with foreigners against U.S. workers and companies are ―anti-American.‖So the
sugar protection policies continue. For the United States, the net cost to the country is close to $2
billion per year. It is not that sugar is so large or important a part of the economy that we have to

protect it. In the United States, about6,000 people work growing sugar, and about12,000 people
work in sugar refining. If we shifted to free trade, employment would probably decline by about
3,000. The small number of people who lose their jobs could be reemployed with little trouble in
other sectors of the economy. Instead,we see the pure political economy of protection,with the
producer interests in this case much better organized and effective than the consumers are.
DISCUSSION QUESTION
A U.S. company (like Jelly Belly) makes its gourmet jelly beans in the United States, and sugar
is about half the cost of production. Can the company change U.S. sugar policy? If not, what are
its other options?
CASE STUDY
In the 1980s,to head off a large number of steel dumping complaints,the U.S. government forced
the EuropeanUnion and other countries to impose voluntary export restraints (VERs). As these
VERs ended,on one day in 1992 American steel firms filed 80 dumping complaints against 20
countries. (Note that American steel producers buy about one quarter of all steel imported into
the United States,in the form of raw steel slabs that they use to make finished steel products.
Amazingly, raw steel slab is apparently never dumped into the United States,but all kinds of
finished steel products are.)American steel firms are well organized.Statisticians at steel-
producer organizations and at individual steel firms closely examine each month's trade data.
When they see an increase of imports in a specific steel product, the American firms are likely to
file a dumping complaint. The American firms actually ―lose‖ or withdraw at least half of these
complaints. But they don't really lose.
For instance, in 1993, American firms filed dumping complaints against exporters of carbon steel
rod. In the early months of the investigation,the price of this product in the UnitedStates
increased by about 25 percent. Eventually,the American firms lost the cases or withdrew the
complaints. An executive of a foreign-owned steel firm commented, ―But who says they lost?I
would say they won. Whatever they spent in legal fees, they probably recouped 50 times in extra
revenue. That is the great thing about filing:Even if you lose, you win.‖*Since the early 1990s
there have been several other bursts of dumping cases filed by American steel firms. In the

aftermath of the Asian crisis of 1997, demand collapsed in the crisis countries(especially Korea,
Thailand, Indonesia, Malaysia,and the Philippines).
Steel firms that had been selling to the crisis countries shifted sales to other countries. In 1998
imports of finished steel into the United States rose rapidly and prices for steel products typically
fell by 20 to 25 percent.
A strong case can be made that 1998 was a fairly typical down phase in the global cycle of a
competitive industry. Still, American firms swung into action. They filed four major dumping
cases in1998 and four in 1999.
The International Trade Commission found injury to U.S. steel firms in six of these cases, and
the Department of Commerce found dumping margins of up to 185 percent. In the large case
involving cold-rolled steel, imports declined by 20 percent in the months after the case was filed,
even though the U.S. firms eventually―lost‖ the case when no injury was found.As prices
remained relatively low around the world, the U.S. steel firms continued to find new dumping.
They brought five major cases in 2000and six major cases in 2001.
* Mr. Nicholas Tolerico, executive vice president ofThyssen, Inc., a U.S. subsidiary of Thyssen
AG, a German steel company. Quoted in The Wall Street Journal ,March 7, 1998.In early 2002
President Bush imposed new general tariffs of up to 30 percent on imports of steel, and the
number of new dumping cases decreased. Under pressure from U.S. steel users and an adverse
WTO ruling, he removed these tariffs in late 2003.
But then global steel prices rose by more than 50 percent during 2004, driven by rapidly rising
demand in China and other developing countries. With strong world prices continuing into 2008,
there were few new anti dumping suits in the United States.As the global crisis hit in 2008, the
steel industry went into recession and the share of the U.S. market served by imports increased.
The U.S. industry filed seven new dumping cases in 2009. After a few years‘ lull, steel imports
into the UnitedStates began to grow rapidly at the beginning of2013, driven both by slowing
demand for steel and excess capacity in the rest of the world and by strong demand in the United
States (especially domestic demand for steel used in oil, natural gas,and automobile production).

The great American steel machine that rolls out complaints about foreign dumping restarted, and
the industry filed seven new dumping cases charging firms from16 countries with dumping
various steel products,the largest being tubular goods for oil production.
Steel remains the U.S. anti dumping king, and the oil industry and many other users of steel in
the United States pay the (higher) price.
DISCUSSION QUESTION
For the U.S. cases alleging dumping filed in 2013, why might the number of these cases that
actually result in the imposition of anti dumping duties turn out to be relatively low?
CASE STUDY
Case Study Agriculture Is AmazingI don‘t want to hear about agriculture from anybody but you .
. . Come to think of it,I don‘t want to hear about it from you either.President Kennedy to his top
agricultural policyadviserAgriculture is another world. Sometimes it seems as if the laws of
nature have been repealed.From the late 1980s to the late 1990s, the desert kingdom of Saudi
Arabia grew more wheat than it consumed, so it was a net exporter of wheat.Wheat is exported
by other countries with unfavorable soils and climates, including Great Britain and France. And
crowded, mountainous Japan has often been a net exporter of rice.All this happens because
governments are more involved in agriculture than in any other sector of the private economy. In
2012 government policies in industrialized countries provided about $259 billion of support to
farmers,equal to about 19 percent of farmers‘ revenues.Government policies in the European
Union(EU) provided $107 billion (19 percent of farm revenues), in the United States $30
billion(7 percent), and in Japan $65 billion (an amazing56 percent of the revenues of Japanese
farmers). The farmers‘ political lobbies in these countries are remarkably powerful, especially
relative to the small role of agriculture in the economy (only about 2 percent of gross domestic
product). Farmers producing rice, milk, sugar,and beef are the biggest recipients of these
subsidies.Close to half of the increased farm income is provided through price supports. For the
typical price support, the government sets a minimum domestic price for the agricultural product,
and the government buys any amounts that farmers cannot sell into the market at the minimum
(support) price. Domestic farmers receive at least the minimum price when they sell, and
domestic consumers pay at least the minimum price when they buy. All of this sounds

domestic—domestic minimum price, domestic farmers, domestic consumers. Yet something that
starts ―domestic‖transforms itself on the way to the global markets.The support price is almost
always higher than the world price for the agricultural product. If the country would import the
product with free trade, the price support requires that imports be restricted . Otherwise, cheap
imports would flood into the country and undermine the price support. If the support price is not
too high (less than or equal to the no-trade price for the country),then the price support is actually
a form of import protection. The analysis of this type of price support mirrors that of import
barriers presented in Chapters 8 and 9. Interesting, but not amazing yet.If the country would
export the product with free trade, but the support price is above the world price, then the
country‘s farmers produce more than is purchased by domestic consumers.The government must
buy the excess production at the high support price. The government could just destroy what it
buys or let it rot, but that would be remarkably wasteful. The government could give it away to
needy domestic families, but there are limits to how much can be given away before this free
stuff starts to undermine regular domestic demand. The government could turn to the export
market, which sounds like an excellent way to dispose of the excess national production.Perhaps
it is, but the government will take a loss on each unit exported. This loss, the difference between
the support price that the government pays and the lower world price that it receives, is an export
subsidy from the government. Foreign buyers will not pay the high domestic support price; they
buy only if the government offers a subsidized export price.In this case, in which an exporting
country sets a support price that is above the world price for the product, the price support policy
is actually a combination of import protection and export subsidy. We are getting closer to
amazing.Price supports can also switch agricultural products from being importable to being
exported . Wheat is an example for Britain,France, and other EU members. Butter and other
dairy products in the EU are other examples of products that have become exports because of
generous price supports. With free trade,wheat, butter, and other dairy products would be
imported into the EU because the world prices of these products are lower than the EU‘s no-trade
prices. (More simply, the EU has a comparative disadvantage in these products.)The EU‘s
support prices are so high that EU farmers produce much more than is sold in the EU.The EU
uses export subsidies to export some of its excess production. The analysis of this case mirrors
that for Figure 11.5. Now that‘s pretty amazing. Domestic price supports morph into a
combination of import protection and export subsidies that transform the country from an

importer to an exporter of the products.It takes a lot of government money to create amazement.
The EU‘s Common AgriculturalPolicy (CAP) covers a broad range of agricultural products
(including wheat, butter, and other dairy products). CAP spending represents over40 percent of
all EU fiscal expenditures. And the amazement brings a large national cost. The inefficiency of
the CAP is equal to a loss of about1 percent of the EU‘s gross domestic product.Agriculture has
also been another world forWTO rules. In contrast to the rules for industrial products,
governments had been permitted to use import quotas and export subsidies. But things are
changing. The agricultural provisions of the Uruguay Round trade agreement made agriculture
less different, especially for developed countries. Governments converted quotas and other non
tariff barriers into tariff rates, a process called tariffication . Each developed country reduced its
budget outlays for export subsidies by 36 percent and its volume of subsidized exports by 21
percent. Each developed country reduced its domestic subsidies to agriculture by 20 percent,
with exceptions. The requirements for developing countries were less stringent.The effects of
these changes are not as large as one might expect. Most developed countries have maintained
import protection through artful implementation of the agreement. Generally,highly protected
products remain highly protected.The reduction of export subsidies has had some impact,
especially in reducing subsidization of exports by the EU. The effects of the general reduction in
domestic subsidies are moderate because major subsidy programs in the United States and the
EU were exempt from the cuts.After the Uruguay Round agreement, agriculture is becoming less
different. One way is that tariffication has placed import barriers into a form in which they can
be compared across countries.A second way is that there is now pressure to reduce the use of
subsidies in agriculture.Countries can use the WTO dispute settlement process to examine
excessive agricultural subsidies.Decisions in 2005 in two major cases—EUexport subsidies for
sugar and U.S. subsidies to cotton—found subsidies that violated WTO rules and
agreements.The Uruguay Round agreement also laid the groundwork for negotiations during the
currentDoha Round that are aimed to achieve more substantial liberalizations. In this sector that
would be amazing.
DISCUSSION QUESTION
For the European Union, can a tariff or import quota turn butter into an EU export product? If
not, why can a price support turn butter into an EU export product?

CASE STUDY
In October 2004, the U.S. government filed a complaint with the World Trade Organization that
the European Union had given and continued to give massive subsidies to Airbus in support of
Airbus‘s production of civil aircraft. Later the same day the European Union filed a complaint
that the U.S. government had given and continued to give massive subsidies to Boeing in support
of its production of civil aircraft. The dogfight over airplane subsidies had moved to the WTO,
with combat in the form of the two largest WTO dispute cases ever.
The story began in the late 1960s, when several national governments in Europe decided to offer
infant industry support to a new airplane producer. The development of Airbus was slow, but in
the 1980s it achieved a share of global deliveries of new civil aircraft (seating more than100
passengers, distinct from smaller ―regional‖ aircraft) of 10–20 percent. As the leading U.S.firm,
Boeing complained to the U.S. government about the subsidies that Airbus was receiving.The
U.S. government began discussions with the European Union. These talks culminated in a 1992
bilateral agreement to restrain subsidies offered by both sides:
• Direct government support for new airplane development (usually called launch aid) limited to
no more than one-third of the total development cost, and only in the form of loans with
minimum required interest rate and maximum repayment period.
• Indirect government support (for instance, research support offered through defense contracts)
limited to no more than 4 percent of a firm‘s civil aircraft sales.
• No production or marketing subsidies, and limits on government financing assistance to

airplane buyers.The limit on launch aid restricted the major way that European governments
have helped Airbus, and the limit on indirect support restricted the major way that the U.S.
government has helped Boeing. Airbus sales continued to grow. By the mid-1990s, Airbus had
about 30 percent of new deliveries and in 2003–2004, Airbus had more than half. Boeing and the
U.S. government became increasingly unhappy with continued Airbus subsidies. They stated that
assistance that might have been suitable when Airbus was an infant was no longer appropriate
when Airbus is grown up and clearly successful.

In 2004 the U.S.government and the EU held discussions to consider revisions to the 1992
agreement but made no progress. In September the U.S. government announced that it was
terminating the 1992agreement as it filed the complaint under the general WTO subsidy
rules.The U.S. government complaint focused on the billions of dollars of launch aid from
European governments to Airbus since its birth.The U.S. government argued that launch-
aidloans provide subsidies because they have artificially low interest rates and pay-back terms
that are conditional on future Airbus sales of the plane being developed.
The U.S. government also complained that Airbus received billions of dollars of other
government subsidies, including other low-cost loans, public investments to assist Airbus in its
production, and R&D contracts that benefit its civil aircraft production.The United States
specifically alleged that Airbus received $6.5 billion in subsidies in support of the development
and production of the new super jumbo A380.For its complaint the EU alleged that Boeing
received billions of dollars in R&D contracts from the U.S. National Aeronautics and Space
Administration and the U.S. Department of Defense, with the results of this research benefiting
its civil aircraft production.
The EU also stated that Boeing received other subsidies, including billions of dollars of tax
breaks from federal, state, and local governments.The WTO cases moved slowly. After filing the
two complaints in October 2004, the U.S. government and the EU negotiated to attempt to
resolve the issues, but they made little progress. In May2005, the U.S. government asked the
WTO to create a panel to hear and judge the case about its complaint, and the next day the EU
responded by asking the WTO to create a panel for its complaint.For the U.S. complaint, the
panel issued its report five years later, in June 2010.
The U.S.government and the EU both appealed certain issues of law and legal interpretations in
the panel decision, and the appeal report was adopted in June 2011. For the EU complaint, the
panel issued its report almost six years later, in March 2011. Again, both sides appealed, and the
appeal report was adopted in March 2012. In the final ruling for the U.S. complaint, the WTO
determined that the EU had provided actionable subsidies to Airbus that had harmed Boeing. The
$15 billion of launch aid included substantial subsidies, and Airbus had received about $5 billion
of other subsidies.

The WTO recommended that the EU withdraw the subsidies or revise them to end the harm to
Boeing. In the final ruling for the EU complaint, the WTO determined that the United States had
provided subsidies to Boeing totaling at least $5 billion, mostly actionable R&D subsidies (about
$3 billion)that had harmed Airbus and prohibited export tax subsidies ($2 billion). The WTO
recommended that the U.S. government withdraw the subsidies or revise them to end the harm
airbus. In December 2011, the EU informed the WTO that it had brought its policies into
compliance.
The U.S. government disagreed, claimed up to$10 billion of continuing injury, and requested
approval to retaliate. The WTO established an arbitration panel to consider retaliation, but the
U.S. government and the EU requested suspension of the arbitration in January 2012. Much the
same sequence played out for the other case. The U.S. government reported compliance in
September 2012. The EU disagreed, claimed up to $12 billion in continuing injury, and
requested approval to retaliate. The arbitration panel was established and then suspended in
November 2012.
Thus, 10 years after the cases were filed, there is no resolution. It is not clear what this protracted
and expensive battle has accomplished.The dogfight seems to have ended in an uneasy draw.It‘s
not so easy, though. Suppose that the U.S. government decides to subsidize Boeing‘s market
entry in the same way that the EU subsidizes Airbus. Then we have the problem shown in panel
B of Figure below. Each firm sees a green light and decides to produce because each firm makes
a positive profit regardless of whether or not the other produces. This is fine for the firms, but
each government is spending 10. So as nations, the EU and the United States are each losing 8
(for each, this equals the 2 of profits that the firm shows minus the 10 of subsidy cost to the
government).
The only good news in panel B is hidden from view: The world‘s consumers gain. But if most of
those consumers are outside the EU and the United States, these two nations are still net losers.
(In the real world both the U.S. government and European governments provide subsidies to
their aircraft manufacturers, and this has led to trade conflict. These simple examples bring out
the two key points about an export subsidy or similar type of subsidy in a global duel between
two exporting giants:

1. The subsidy might be a good thing for the exporting country, as shown in panel A in Figure,
but
2. The case for giving the subsidy is fragile, depending on too many conditions to be a reliable
policy. In our example, we saw one condition that matters. If another national government also
offers its firm strategic policy assistance, it is quite possible that both countries lose well-being.
Another condition that matters is the possibility that there is no prize for the game. For instance,
there may not be enough consumer demand for the new product, so economic profits will be
negative instead of positive, even if there is only one producer.
How would the government separate the false pleas of some of its firms for strategic help from
the valid ones? While there is a theoretical case for the national benefit of strategic trade policy,

we may be skeptical that a national government could actually use it effectively.
Case Study
Postwar Trade Integration in Europe
1950–1952: Following the Schuman Plan, ―the six‖ (Belgium, France, West Germany, Italy, the
Netherlands, and Luxembourg) set up the European Coal and Steel Community. Meanwhile,
Benelux is formed by Belgium, the Netherlands, and Luxembourg. Both formations provide
instructive early examples of integration.

1957–1958: The six sign the Treaty of Rome setting up the European Economic Community
(EEC, or ―Common Market‖).
Import duties among them are dismantled and their external barriers are unified in stages
between the end of 1958and mid-1968. Trade preferences are given to a host of developing
countries, most of them former colonies of EEC members.1960: The Stockholm Convention
creates the European Free Trade Area (EFTA) among seven nations: Austria, Denmark, Norway,
Portugal, Sweden, Switzerland, and reunited Kingdom. Barriers among these nations are
removed in stages, 1960–1966.
Finland joins EFTA as an associate member in 1961. Iceland becomes a member in 1970,Finland
becomes a full member in 1986, and Lichtenstein becomes a member in 1991.1967: The
European Community (EC) is formed by the merger of the EEC, the EuropeanAtomic Energy
Commission, and the European Coal and Steel Community.
1972–1973: Denmark, Ireland, and the UnitedKingdom join the EC, converting the six into nine.
Denmark and the United Kingdom Velveeta.
The United Kingdom agrees to abandon many of its Commonwealth trade preferences.Also, Ode
to Joy from Beethoven‘s NinthSymphony is chosen as the EC‘s anthem.
1973–1977: Trade barriers are removed in stages, both among the nine EC members and
between them and the remaining Emanations. Meanwhile, the EC reaches trade preference
agreements with most nonmember Mediterranean countries along the lines of earlier agreements
with Greece (1961), Turkey(1964), Spain (1970), and Malta (1970).
1979: European Monetary System begins to operate based on the European Currency Unit.
The European Parliament is first elected by direct popular vote.
1981: Greece joins the EC as its 10th member.1986: The admission of Portugal and Spain brings
the number of members in the EC to 12.
1986–1987: Member governments approve and enact the Single European Act, calling for a fully
unified market by 1992.

1989–1990: The collapse of the East German government brings a sudden expansion of
Germany and therefore of the EC. East Germans are given generous entitlements to the social
programs of Germany and the EC.
1991–1995: Ten countries from Central and Eastern Europe establish free-tradeagreements with
the EC. All become EU members in 2004 and 2007. End of 1992: The Single European Act
takes effect, integrating labor and capital markets throughout the EC.
1993: The Maastricht Treaty is approved, making the EC into the European Union (EU), which
calls for unification of foreign policy, for cooperation in fighting crime, and for monetary union.
1994: The European Economic Area is formed, bringing the EFTA countries (except
Switzerland) into the EU‘s Single EuropeanMarket.
1995: Following votes with majority approval in each country, Austria, Sweden, and Finland join
the EU, bringing the number to 15. As it had done in 1972, Norway rejects membership in its
1994 vote.
1996: The EU forms a customs union with Turkey
1999: Eleven EU countries establish the euro as a common currency, initially existing along
with each country‘s own currency. Greece becomes the 12th member of the euro area in 2001.
2002: The euro replaces the national currencies of the 12 countries.
2004: Ten countries (Estonia, Lithuania, Latvia, Poland, Czech Republic, Slovakia, Hungary,
Slovenia, Malta, and Cyprus) join the EU, bringing the total number to 25.
2007: Romania and Bulgaria join the EU, bringing the total number to 27. Slovenia joins the
euro area.
2008: Cyprus and Malta join the euro area.
2009: Slovakia joins the euro area.
2011: Estonia joins the euro area.
2013: Croatia joins the EU, bringing the total number to 28.

2014: Latvia joins the euro area, bringing the total number of EU countries using the euro as
their currency to 18.
DISCUSSION QUESTION
Which country do you think will be the next country to join the EU?
CASE STUDY
Dolphins, Turtles, and the Dolphins have long had a special appeal to humans because of their
intelligence and seeming playfulness. The sympathy for dolphins, like the sympathy for all large
animals, grows with income. It was inevitable that any threat to dolphins, even though they are
not an endangered species, would mobilize a strong defense in the industrialized countries. Most
tuna are caught by methods that do not harm dolphins. But, for unknown reasons, large schools
of tuna choose to swim beneath herds of dolphins in the Eastern Tropical Pacific Ocean.
Before 1960, this posed no threat to dolphins. Fishing crews used hooks to catch tuna, and
dolphins‘sonar allowed them to avoid the hooks.However, the 1960s brought a new method for
catching tuna, purse-seine fishing, in which speedboat sand helicopters effectively herd the
dolphins and tuna into limited areas, where vast nets encircle large schools of tuna.
As the nets draw tight underwater, the dolphins, being mammals, drown. Six million dolphins
have died this way since 1960.The United States tried to stop this purse-seinenetting with the
Marine Mammals Protectionist of 1972, but with limited effect. The law can prohibit use of this
method in U.S. waters, outto the 200-mile limit, and use of this method by U.S. ships anywhere
in the world.
Fishing fleets responded to the 1972 law by reflagging as ships registered outside the United
States. Between1978 and 1990, the share of U.S. boats in the Eastern Pacific tuna fleet dropped
from 62 percent to less than 10 percent. The United States still had some economic weapons at
its disposal. The government pressured the three main tuna-packing and tuna-retailing firms
(Starkest, Bumble Bee, and Chicken of the Sea) to refuse to buy tuna taken with dolphin unsafe
methods.

While there were charges that at least one of the firms packed dolphin-unsafe tuna under its
dolphin-safe label, the dolphin-safe scheme had some success. Through this and other forms of
pressure, the estimated dolphin mortality in tuna fishing dropped from 130,000 in 1986 to25,000
in 1991.The United States did not let the matter rest there. In 1991, the U.S. government banned
tuna imports from Mexico and four other countries.
Mexico immediately protested to the GATT, wherea dispute resolution panel handed down a
preliminary ruling that the U.S. import ban was an unfair trade practice, a protectionist act
against Mexico.The GATT panel ruled that the United States cannot restrict imports based on
production methods used by firms in other countries.
The EU also challenged the U.S. legislation as a violation of the GATT because it included a
―secondary boycott‖ against tuna imports from any country importing dolphin-unsafe tuna from
countries like Mexico that use this fishing method.
In 1994, a GATT panel again ruled against the United States. These rulings suggested that
international trade rules would not endorse efforts by one country to use trade policy to impose
its environmental policies outside of its borders, or to force other countries to change their
environmental policies. Environmentalists were furious because they believed that principles of
trade policy wereplaced ahead of environmental safeguards.
Within these constraints, what can the United States do if it wishes to save more dolphins?
One possibility is to negotiate with other countries to get them to alter the methods they use to
catch tuna, perhaps by offering other benefits in exchange. In 1995, six countries (including
Mexico) agreed to adopt dolphin-friendly fishing.
However, some fishing fleets could just reflag to yet other countries, so the best solution
probably would be a global multilateral agreement on tuna fishing.
Sea turtles, a species threatened with extinction, present a similar case. Some shrimp are caught
with nets that also trap and kill sea turtles. A U.S. law passed in 1989 requires shrimpers in U.S.
waters to alter their nets with turtleexcluder devices, and it prohibits shrimp imports from
countries whose rules do not require such devices to protect sea turtles.

The U.S. government initially applied the U.S.law to 14 Caribbean and Latin American
countries, negotiated with them, and allowed them three years to implement changes in their
fishing methods. Following a U.S. court ruling, the U.S.government extended the application of
the law to other countries unilaterally and with only a four-month phase-in. Four Asian countries
filed a complaint with the WTO in 1997. In the ruling on the case, the WTO decided that
Protection of sea turtles was a legitimate environmental purpose.
• The actual U.S. policies violated WTO rules because they did not apply equally to all foreign
exporting countries.
• The actual U.S. policies were unacceptable because they required specific actions by the
foreign countries (enacting laws and usingturtle-excluder devices) and did not recognize
alternative ways to protect sea turtles.
• The actual U.S. approach was also unacceptable because the U.S. did not undertake
negotiations with the exporting countries affected by the extension of application of the law. In
response to the ruling, the U.S. government removed the discriminatory terms, recognized other
turtle-protection methods, and began negotiations with the countries affected by the extension of
the law.
In 2001 the WTO ruled that, with these changes in place, the United States was in compliance
with WTO rules, so it could restrict imports of shrimp caught in ways that harm sea turtles. The
WTO also ruled that good-faith negotiations toward a multilateral agreement were adequate—
reaching an actual agreement was not a prerequisite for the United States to apply its law. At
about the same time as the WTO rulings, the United States did reach agreements with a number
of foreign countries to adopt rules to protect sea turtles.
Many environmentalists seem to believe incorrectly that WTO rules always favor free trade and
so prevent a country from using trade related measures as part of its efforts to protect the
environment. The truth is more nuanced.The WTO is certainly vigilant against environmental
policies and rules that unnecessarily limit trade or discriminate between foreign suppliers. Still,
the WTO cannot force a member country to change its policies if the country does not want to.

More important, the WTO generally accepts the legitimacy of protecting the environment and
setting minimum environmental standards through negotiations between countries. The appellate
body in the sea turtle case said in its report:We have not decided that protection and preservation
of the environment is of no significance to the members of the WTO.
Clearly it is. We have not decided that the sovereign states that are members of the WTO cannot
adopt effective measures to protect endangered species, such as sea turtles. Clearly, they can and
they should. And we have not decided that sovereign states should not act together bilaterally,
plurilaterally, or multilaterally, either within the WTO or in other international fora, to protect
endangered species or to otherwise protect the environment.
Clearly, they should and do.
Case Study Special Challenges of Transition
In 1989, a massive transition from central planning to market economies began in the formerly
socialist countries of Central and Southeastern Europe. With the breakup of the Soviet Union
in1991, the former Soviet Union countries joined this transition. This is the most dramatic
episode of economic liberalization in history. What role have changing policies toward
international trade played in the transition?
Prior to 1989–1991, central planning by each government directed the economies in these
countries. National self-sufficiency was a policy goal. Imports were used to close gaps in the
plan, and a state bureaucracy controlled exports and imports. When trade was necessary, the
countries favored trade among themselves and strongly discouraged trade with outside countries.
They tended to use bilateral barter trade, with lists of exports and imports for each pair of
countries.
The trade pattern had the Soviet Union specializing in exporting oil and natural gas (at prices
well below world prices) and other countries exporting industrial and farm products. As the
transition began, these countries had a legacy of poor decision-making under central planning,
including over development of heavy industries (like steel and defense), outdated technology,
environmental problems, and little established trade with market economies. They needed to
remove state control of transactions and undertakea major reorganization of production.

Transition involves accomplishing three challenging tasks:
(1) shifting to competitive marketsand market-determined prices, with a new process of resource
allocation;
(2) establishing private ownership, with privatization of state businesses; and
(3) establishing a legal system, with contract laws and property rights.
For success, the transition process must
• Impose discipline on firms inherited from the era of central planning
.• Provide encouragement for new firms that arenot dependent on the government. Opening the
economy to international trade and direct investments by foreign firms can be part of both the
discipline (through the competition provided by imports) and the encouragement(through access
to new export markets and to foreign technology and know-how).
Domestic and international reforms usually advanced together in a transition country, and
success requires a consistent combination of reforms. We can identify several groups of
countries that pursued reforms in different ways and at different speeds.The Central European
countries (Czech Republic, Hungary, Poland, Slovakia, and Slovenia), the Baltic countries
(Estonia, Latvia, and Lithuania), and the Southeastern European countries (Albania, Bosnia,
Bulgaria, Croatia, Macedonia, Montenegro, Romania, and Serbia) pursued strong, rapid
liberalizations(except for Bosnia, Serbia, and Montenegro, which were involved in fighting).
The Central European and Baltic countries joined the European Union in2004, Bulgaria Romania
joined in 2007, and Croatia joined in 2013.The members of the Commonwealth of Independent
States (CIS, the countries that were formerly part of the Soviet Union, excluding the Baltic
countries) have instead followed paths of less liberalization.
Three countries, Belarus, Turkmenistan, and Uzbekistan, continue to resist enacting reforms. The
other CIS countries (Armenia, Azerbaijan, Georgia, Kazakhstan, Kyrgyz Republic, Moldova,
Russia, Tajikistan, and Ukraine) enacted partial reforms that were adopted slowly over time and
that sometimes were reversed. How do trade patterns evolve during transition? One pressure is
clear, toward rapid growth of imports, especially consumer goods, based on pent-up demand.

Transition countries must export to pay for their rising imports, and Western Europe and other
industrialized countries are crucial as major markets for expanding their exports.However,
exporting to demanding customers in the competitive markets of the industrialized countries was
not going to be easy. Under central planning these countries had major deficiencies in their
products and businesses, including poor product quality, lack of marketing capabilities, and lack
of trade financing. How successful have the transition countries been in reorienting their trade
patterns?
By 1998the Central European, Baltic, and Southeastern European countries on average were
selling over60 percent of their exports to buyers in industrialized countries. Rapid and deep
liberalizations, along with favorable geographic location close to the markets of Western Europe,
have facilitated the shift by these countries to a desirable export pattern.
They increased their exports of light manufactured goods like textiles, clothing, and footwear.
They also used their low-costskilled labor to expand export of such products as vehicles and
machinery. In contrast, most CIS countries did not reorient their exports much, and on average
only about a quarter of their exports went to industrialized countries in the late 1990s. Many
countries resisted trade liberalizations and continued to producelow-quality manufactured
products that could not be exported outside the region.
As of early2014, only 7 of the 12 CIS countries had become members of the World Trade
Organization. How does all of this combine to determine the success of economic transition?
One broad indicator is the growth or decline of domestic production (real GDP). In the beginning
transition is likely to cause a recession, as business practices and economic relationships are
disrupted. Only after reforms begin to take hold can the economy begin to grow. This process is
like that of the shift from no trade to free international trade.
The gains from opening to trade are based largely on disrupting previous patterns of production
and consumption activities.The evidence indicates that the depth and speed of reforms matter for
the success of transition. In addition, as with developing countries generally, we see greater
success for those countries adopting more open and outward-oriented trade policies.The fast and
deep reformers in Central southeastern Europe suffered through early transition recessions that

were not that deep and not that long. The recessions in the Baltic countries were somewhat
longer and somewhat deeper.
Then, starting between 1992 and 1996,each of these countries has generally had substantial and
sustained growth.The nine partial-reform and less open Viscountcies have broadly performed the
worst, even compared with the three non reform Viscountcies. Most partial-reform CIS countries
experienced deep early-transition recessions, and three (including Russia) did not return to
sustained growth until 1998 or later. They seemed to be caught in a trap in which special
interests, oligarchs, and insiders who benefit from the partial reforms gain the political power to
block or slow further reform. One advantage of speed in reform is that the reforms are enacted
and the increased international trade and greater market competition impose discipline and offer
encouragement, before such special interest groups have time to coalesce and exert their power.
DISCUSSION QUESTION
Based on the international economics of the situation, should a country like Ukraine strengthen
its orientation toward the customs union that includes Russia and several other CIS countries or
reorient itself more toward the European Union?
CASE STUDY
Multinationals succeed by using their firm-specific advantages throughout their global

operations. We have also noted that most foreign direct investments are made by firms based in
the industrialized countries.
This is the story of CEMEX, a firm that rapidly has become multinational since 1990. The
reasons for its multinational success fit very well with the advantages stressed in the eclectic
approach. What makes the firm unusual is that it is based in Mexico. CEMEX is an example of a
growing group of multinationals based in developing countries.CEMEX began business in 1906.
For most of its life this cement company focused on selling in the Mexican market. Cement is a
product that is expensive to ship, especially overland, so cement plants ship mostly to customers
within 300 miles of a plant. Shipment by water is moderately (but not prohibitively) expensive.
Most cement producers in the 1980s were local producers with traditional business practices.
New managers at Pembroke with tradition by introducing extensive use of automation,

information technology, and asatellite-based communication network into Cyberoperations. They
used the technology to improve quality control and to provide detailed information on
production, sales, and distribution to top managers in real time. Delivery of ready-mix concrete
is particularly challenging in cities. Traditionally, cement firms could ensure delivery only
withina time period of about three hours.
CEMEX pioneered the use of computers and a global positioning system to guarantee delivery to
construction sites within a 20-minute window. These innovations became the company‘s firm-
specific advantages.Also in the 1980s CEMEX began to export more aggressively to the United
States using sea transport, and it was increasingly successful. However, competing U.S. cement
producers complained to the U.S. government, and in 1990 CEMEX exports to the United States
were hit by a 58 percentantidumping duty. With exporting to the United States limited by the anti
dumping order, CEMEXlooked for other foreign opportunities. In 1991, it began exporting to
Spain, and in1992 it made its first foreign direct investment by acquiring two Spanish cement
producers.CEMEX minimized its inherent disadvantages by investing first in a foreign country
with the same language as the firm‘s home country and a similar culture.
In addition, CEMEX used its expansion into Europe as a competitive response to the previous
move by the Swiss-based firm Holcim into the Mexican cement industry.The management team
sent by CEMEX to reorganize the acquired companies was amazed to find companies that kept
handwritten records and used almost no personal computers. They upgraded the Spanish
affiliates to CEMEXtechnology and management practices. The improvement in affiliate
operations from this internal transfer of CEMEX‘s intangible assets was remarkable—profit
margins improved from 7percent to 24 percent in two years.
Since then, CEMEX has made a series of foreign direct investments by acquiring cement
producers in Latin America (including Venezuela, Panama, the Dominican Republic, Colombia,
and Costa Rica), the United States, Britain, the Philippines, Indonesia, and Egypt. CEMEX used
the same type of process that it used in Spain to bring its technology and management practices
into its new foreign affiliates, and generally achieved similarly impressive improvements in
performance.

By 2000, CEMEX was the third largest cement producer in the world, behind Lafarge of France
and Holcim. More than 60 percent of its physical assets were in its foreign affiliates. It was also
the largest exporter of cement in the world (a fact consistent with the proposition discussed in the
text that FDI and trade are often complementary).CEMEX is considered one of the best
networked companies globally by computer industry experts, well ahead of its rivals. Its
investments in developing and enhancing its firm-specificadvantages have been paying off
globally.
DISCUSSION QUESTION
In countries like Spain, Colombia, and the Philippines, why did CEMEX not just license
independent local producers to use its operations technologies?
CASE STUDY
In 1978 the Chinese government began a process of slowly opening China to direct investments
by foreign multinationals. The cumulation of liberalizations paid off in the 1990s, when annual
inflows of FDI increased 10-fold from 1991 to1997. Inflows since then have remained strong,
and during 2010–2012 China was the second largest recipient of direct investment flows in the
world (behind only the United States).
* About half of FDI into China is in manufacturing, and foreign affiliated firms account for
about one-third of production value added in Chinese manufacturing. Where is all of this FDI
coming from? China has been unusual in that much of the FDI has come from developing
countries located close to it, not from the industrialized countries whose firms are the source of
most FDI worldwide. Firms from Hong Kong and Taiwan have been attracted to China because
they were seeking low-cost labor and land(location factors) to produce products like clothing,
toys, and shoes, and to assemble products like consumer electronics, for export to third countries.
They faced rather low inherent disadvantages,based on their cultural and geographic proximity,
and their moderate firm-specific advantages, based on their knowledge of their businesses, were
sufficient to allow them to be generally successful in China. Firms from Hong Kong and Taiwan
were also comfortable forming joint ventures with Chinese firms—such joint ventures were
previously mandated by the Chinese government and still are required for some industries.

The surge of FDI into China in the 1990s corresponded to the growth of FDI by the more typical
MNEs based in industrialized countries. These firms, in such industries as autos, machinery, and
chemicals, faced larger inherent disadvantages, but they also had more substantial firm-specific
advantages. Increasingly they have used wholly owned Chinese subsidiaries rather than joint
ventures, as they have gained experience in operating in China and as the Chinese government
has become more tolerant of full foreign ownership. While some of their operations were geared
to exporting, a key location factor for many of them has been using local production as the base
for gaining sales in the rapidly growing Chinese market (incomes have grown rapidly, and a
substantial urban middle class has developed).
Oligopolistic rivalry among firms from industrialized countries reinforced the rush to China in
some industries (for instance, autos). One constraint on firms from industrialized countries is that
it has been very difficult to enter or expand by acquisition of local Chinese firms. A key issue for
a foreign firm in China is protection of its intellectual property (patents, trade secrets, brand
names, trademarks, and copyrights).
Like many other developing countries, China has good intellectual property laws but weak
enforcement. A foreign firm contracting with an independent Chinese firm, say, for the
production of its brand-name products, risks losing some control of its brand. This happened to
the sneaker company New Balance when one of its contract manufacturers in China produced
hundreds of thousands of pairs beyond what New Balance ordered and then sold the sneakers
both locally and internationally. A foreign firm sees the internalization advantages of managing
its intellectual property in China by owning and controlling its Chinese operations.
For instance, the Japanese firm Mutsuhito Electric makes sure that each of its Chinese
employees knows only a small part of the overall production process for its most advanced
products, so no employee can leave with its advanced technologies.*One should interpret
economic data on China with some caution, though there is no doubt that China‘s inflows of FDI
are large. In addition to the usual concerns about the accuracy of the data, there is one interesting
feature of FDI into China that skews the data.

Some substantial amount of the recorded FDI is actually not FDI at all, but what is called round-
tripping. That is, firms and individuals in China find ways to shift funds out of China, usually to
Hong Kong, and then use these funds to make ―foreign‖ direct investments back into China.
They do this to gain the incentives and favorable treatment given by the Chinese government to
―foreign-owned‖ firms. A typical guess is that perhaps 20 to 25 percent of Chinese FDI inflows
have actually been round-tripping. Another use of location factors is to understand where within
China the foreign-affiliatedfirms are located. Most FDI into China is located in the coastal areas
of eastern China. These areas were opened to FDI earlier than the rest of the country; they have
better transportation and communication infrastructure, including port facilities for exporting;
and they have stronger consumer markets because they have higher per captaincies.
Guangdong Province alone is host to about one-sixth of all Chinas FDI. Its early advantages
were that it borders on Hong Kong and that it had three of the first four Special Economic zones,
established by the central government in 1979 to offer foreign firms preferential treatment and
fewer restrictions on their local operations. Inflows of FDI are generally viewed as benefiting
China‘s economic development.
A study by the Organization for Economic Cooperation and Development concluded that FDI
has assisted the development of new industries in China, offered new and better products to
Chinese consumers, brought new technologies to China, offered employment to Chinese
workers, provided them with training and experience that has allowed them to build their
technological and managerial skills, and increased China‘s exports. For exports, China is a good
example of how FDI and trade are complements—foreign-affiliated firms makeover half of
China‘s exports.
In addition, other research suggests that the presence of foreign affiliated firms has led to
increases in the productivity of local firms. Part of this productivity effect may be spillovers of
technologies and workers kills. Another part of the effect may be the pressure of increased
competition, as local firms are forced to ―dance with wolves.‖ Policies of China‘s government
continue to influence FDI into China. China has a complex system of screening and approvals
for the entry of foreign firms into China, including both public(published) rules and internal
(unpublished)rules.

Some screening and approval are done at the central (national) level, and some are done at the
local level. There are four categories by industry or type of operation:
• Some types of FDI, including investments that bring in advanced and environmentally friendly
technologies, are encouraged, so they receive incentives and privileges, like low taxes for
extended time periods.
• Some types of FDI, including investments that use old technologies and investments in many
mining and service industries, are restricted, so they get additional scrutiny before approval.
• Some types of FDI, including investments that would be highly polluting, investments in
defense industries, and investments in traditional Chinese crafts, are prohibited.
• All other types of FDI not named in the first three categories are permitted.The complexity and
time needed to gain approvals act as a disincentive for foreign firms to invest in China. In
addition, the Chinese government imposes some forms of operating requirements on foreign-
owned affiliates.
The ones related to exports and local content generally have declined as China has implemented
the liberalizations that it committed to when it joined the WTO. The major remaining
performance requirement is pressure from the Chinese government to transfer foreign
technologies to Chinese firms (often, to the local partners in joint ventures), as General Electric
is doing in its joint venture that produces and sells advancedelectricity-generating turbines.
China‘s government also offers a variety of incentives to FDI, including tax breaks, low rents on
land, and provision of infrastructure improvements.
Overall, though, the Chinese government does not usually engage in ―bidding wars‖ with other
countries to attract FDI. Beginning in 2006, the Chinese government began to shift its policy on
inbound FDI, stating that it would focus more on the quality of the investments and de-
emphasizing the quantity of investments. It tightened some restrictions on foreign acquisitions of
Chinese publicly traded companies. In 2008, it implemented a change in its tax law, eliminating
or starting the phase-out of many of the tax incentives that it had offered to foreign-owned firms.
In 2011, it added to the list of encouraged investments: components for alternative-

energyvehicles, next-generation Internet products, biotechnology, intellectual property

consulting firms, venture capital firms, and waste-recycling firms. It moved from restricted to
permitted medical facilities and services, financial leasing firms, distribution and import of
newspapers and books, and carbonated soft drinks. It moved automobile design and
manufacturing from encouraged to permit. It moved domestic mail courier services and the
construction of luxury villas to prohibited.
One way that China has looked different from much of the rest of the world is that most FDI into
China has been in manufacturing. The changes in China‘s policy since 2006 are likely to shift
manufacturing FDI away from unskilled-labor-intensive production (e.g., toys) and assembly
(e.g., electronics products). It remains to be seen if there will also be a shift toward FDI in
service industries.
As part of the obligations that the Chinese government accepted to join the WTO, it agreed to
liberalize entry and ownership limits in a range of services, including banking and finance,
distribution, retail and wholesale, advertising, architecture, engineering, and law. In some of
these industries the government has used regulations to slow the process.
It now appears that with the recent policy shift the government will allow or encourage FDI in
some service industries while becoming more restrictive in others.
CASE STUDY
Are Immigrants a Fiscal Burden?
It is widely suspected that immigrants are a fiscal burden, swelling the rolls of those receiving
public assistance, using public schools, and raising police costs more than they pay back in taxes.
This suspicion was the basis for a U.S. law that made immigrants (both legal and
illegal)ineligible for some forms of public assistance. This suspicion, applied to illegal
immigrants, was the basis for citizens first in California, and later in Arizona, to vote to deny
public services to immigrants whose papers are not in order.
Are immigrants a burden to native taxpayers?
The answer to this question is more complicated than it sounds, for two reasons:

• While some effects are easy to quantify using government data, other effects must be estimated
without much guidance from available data.
• The full fiscal effects of a new immigrant occur over a long time—the immigrant‘s remaining
lifetime and the lives of her descendants. Let‘s look first at the effects of the set of immigrants
that are in a country at a particular time. This kind of analysis provides a snapshot of the fiscal
effects of immigrants during a year. We can see clearly what we can and cannot quantify well,
but we do not see effects over lifetimes.The Organization for Economic Cooperation and
Development (2013, Chapter 3) examined the fiscal effects of immigrants in each of a number of
countries during 2006–2008. Part of the analysis was relatively easy.
The OECD researchers had good information on direct financial payments to and from the
government. The immigrants‘ payments to the government include income taxes and social
security contributions. Government payments to the immigrants include public pensions and
transfers for public assistance, unemployment and disability benefits, family and child benefits,
and housing support. If these were all the fiscal effects of immigrants, then, in most countries
examined, immigrants made a positive net fiscal contribution. The first column of the table
shows the sizes of the net direct payments as a percent of GDP, for a few countries from the
study.
For Germany, the net effect of immigrants was negative because many immigrants in Germany
are pensioners (Turks who arrived as guest workers in the 1960s and refugees from the former
Soviet Union who arrived in the 1990s).The remaining part is hard.
Immigrants pay other kinds of taxes, including value added or sales taxes and, indirectly,
corporate income taxes. And immigrants share in using all kinds of public services, including
schools, medical care, training and labor market assistance, infrastructure, police, public
administration, and defense. How much does immigrants‘ use of each of these items expand
government spending on it? The answer varies by the type of service and immigrants‘use.
Immigrants probably have almost no effect on national defense expenditures. (Indeed, they might
add effective soldiers.) Immigrants‘use of education and health services probably does require
additional government expenditures to maintain the same level of services to everyone else.

Immigrants‘ use of transport infrastructure, police services, and similar items may require some
expansion of government expenditure on these items.
The hard part is that there is no good way to know how much immigrants expand government
expenditures on most of these items. To go further, we must make assumptions.The OECD
researchers made assumptions to allocate these items (excluding defense spending and interest
on government debt), generally by using per person estimates of the items. The second column
of the table shows the estimates for the net fiscal effects of both the direct payments and the
allocated items. Based on the assumptions used by the researchers, the allocated items are net
negative for most countries, including the five shown here.
For the United States, the estimated net fiscal effect of its immigrants shifts from a positive
contribution to a negative―burden.‖ However, perhaps the most defensible conclusions are that,
for most countries including the United States, the current fiscal effects of immigrants are
challenging measuring and probably are relatively small.
Another way to look at the fiscal effects of immigrants is over their entire remaining lifetimes,
and even to examine the fiscal effects of their descendants. For government programs that have
costs for recipients of some ages but generate tax revenues from these same recipients at other
ages, the lifetime approach is the more sensible way to calculate the fiscal effects of a small
increase in immigration. One example is public schooling. Immigrants‘ children increase the cost
of providing public schooling. But the schooling increases the children‘s future earnings, so the
government eventually collects more taxes.
Another example is social security. While working, immigrants pay social security taxes, but in
the future they will collect social security payments. Analysis of the fiscal effects of immigrants
over lifetimes is complicated and requires many assumptions, including assumptions about how
much immigrants add to costs as they consume various public services. Smith and
Edmonton(1997, Chapter 7) examine the lifetime fiscal effects of typical immigrants in the
United States as of 1996. Over the lifetime of the average immigrant(not including descendants),
the net fiscal effect is slightly negative, about $3,000 net cost to native taxpayers. However, the
effect depends strongly on how educated the immigrant is.(Education is used as an indicator of
earnings potential based on labor skill or human capital.)

• The average immigrant who did not complete high school imposes a lifetime net cost
of$89,000
.• The average immigrant who is a high school graduate imposes a net fiscal cost of $31,000.
• The average immigrant who has at least one year of college provides a lifetime net fiscal
benefit of $105,000. These findings indicate that the fiscal effects of immigrants depend very
much on the levels of labor skills of the immigrants.
More-educated, more-skilled immigrants have higher earnings, resulting in larger payments of

taxes. Immigrants with greater skills and higher earnings are also less likely to use public
assistance. In addition, Smith and Edmonton conclude that the descendants of the typical
immigrant provide a net fiscal benefit of $83,000. Thus, the typical immigrant and her
descendants provide a net fiscal benefit of $80,000 (5 $23,000 $183,000).
Interestingly, this net fiscal benefit is not spread evenly over government units. State and local
governments bear a net fiscal cost of $25,000, while the U.S. federal government receives a net
benefit of $105,000.
* We can see a clear basis for tension between states and the federal government over
immigration policies. Especially, we can see the basis for California's efforts to limit its outlays
for immigrants because California has by far the largest proportion of immigrants of any state.

DISCUSSION QUESTION
Immigrants, compared to natives in a country, tend to be young, to have lower wage rates, to be
healthier, and to have more children. For fiscal effects for this country, how do these
characteristics of immigrants matter?
* This differential is not unique to immigrants. The typical native-born child also imposes a net
cost on state and local governments. They largely bear the costs of education, health care, and
other transfers early in the child‘s life, while the federal government collects most of taxes paid
after the child grows up.

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HIMACHAL PRADESH NATIONAL LAW UNIVERSITY,

B.A./B.B.A. LL.B. (H) Paper Code: B.A./B.B.A__

(Economics of International Trade)

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Introduction to International Economics and Trade Theories

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Features of Foreign Trade of India are:

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6. Trade through a few Selected Ports Only:

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2. Differences in Natural Resources:

3. Geographical and Climatic Differences:

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7. Problem of Balance of Payments:

8. Different Transport Costs:

9. Different Economic Environment:

10. Different Political Groups:

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As remarked by Friedrich List, “Domestic trade is among us, international trade is

11. Different National Policies:

Theory of Absolute Advantage

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Table 1.3: Gain in Output when labour resources are transferred

U.S.A India World Output

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Assumptions in Absolute Advantage

1. Lack of Mobility for Factors of Production

4. Constant Returns to Scale

The Theory of Comparative Advantage

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3. Complete specialisation might create structural unemployment as some workers cannot

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8. According to influential US economist Paul Krugman, the continual application of

Theory of Opportunity Costs

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Theory of Heckscher-Ohlin Theory of Trade

i. No Need for a Separate Theory:

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iii. Supplement to Ricardian Theory:

v. Statement of the Theory:

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vi. Pattern of Trade:

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 Efficient deployment of productive resources to their best uses, productivity gains,

 Enhanced foreign exchange reserves, increased scope for mechanization and

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 The Heckscher-Ohlin theory of trade, also referred to as Factor-Endowment Theory of

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