Module 4

International trade leads to increase in world production, increase in

consumption and increase in economic welfare.
 -> Ricardo's principle of Comparative
Cost Advantage:
• According to Ricardo it's not the absolute but the comparative difference in cost that
determines trade relations between the two countries. Production cost differ in
country because of geographical, D.O.L., and specialization in production due to
differences in climate natural resources, geographical situation and efficiency of
labour a country can produce commodity at a lower cost than the other.
•  In this way each country Specializes in the production of commodity in which its
cost is less. Thus, when a country enters in a trade with some other country it will
export those commodities in which the comparative cost is less & those will import
those commodities in which the comparative cost is more This is the basis of
international trade.
• According to Ricardo each country will specialize in production of those
commodities in which it has greater advantage or least comparative disadvantage.
Example
• Portugal 80hrs of Labour produces 1 Unit of Wine
• England 120hrs of Labour produces 1 Unit of Wine

• Portugal 90hrs of Labour produces 1 Unit of Cloth

• England 100hrs of Labour produces 1 Unit of Cloth
• After calculating comparative cost ratios it is found that for portugal the C. C. R.s are less in both the goods. So Portugal has a
greater C.C. Advantage over England in the production of both the goods. But the the cost of advantage is greater in the
production of wine then in the  production of cloth because the ratio 80/90 < 90/80 (i.e. 1.125>0.89) 
• At the same time for England though the comparative Cost Ratios are more, its "comparative cost disadvantage is lesser in the
production of cloth because 100/120 < 120/100

• Hence, Portugal would specialize in the production of wine & England in the production of cloth.

• -> Increase in World Production 

•  If there is no trade between them then, 
• Portugal produces I unit of wine & 1 unit of cloth with 80+ 90=170 hrs. of labour & England will use 120+100=220 hrs. of labour.

• However, after specialization Portugal, would divert 170 hour of labour to produce wine only and England will divert 220 hrs of
labours to produce cloth only.
• Hence the output of wine in Portugal would be 170/80=2.125 units of Wine and output of cloth in England would be
220/100=2.2 units of cloth. 
• Hence the same amount of Labour Produces a larger amount of commodities after specialization and international trade.
Heckscher-Ohlin theory OR 2x2x2 model
• The theory believes that different countries are endowed with varying proportions of different factors of production.

• Some countries have large population and large labour resource. The others have abundance of capital but short of labour resource.

• Capital abundant country presents a higher capital ratio than what a labour abundant county presents.

• Thus, a country with large labour force will be able to produce those goods at lower cost that involve labour intensive mode of production.

• Similarly the countries with large supply of capital will specialize in those goods that involve capital intensive mode of production.

• The former will export its labour intensive goods to the latter and import capital intensive goods there from.

• After the trade, both the countries will have both types of goods at the least cost.

• All this means that the theory holds good if the capital abundant country has a distinct preference for the labour-intensive goods and the
labour abundant country has a distinct preference for capital intensive goods. If it is not, the theory may not hold good.

• Again, the theory does not hold good if the labour abundant country is technologically advanced in capital intensive goods or if capital
abundant economy is technologically advanced in the production of labour intensive goods.

• Limitation: Leontief paradox: Leontief's paradox in economics is that a capital intensive country has a lowercapital intensive goods in exports
 than in imports.
• This econometric finding was the result of Wassily W. Leontief's attempt to test the Heckscher–Ohlin theory ("H–O theory") empirically. In 1953,
Leontief found that the United States—the most capital-abundant country in the world—exported commodities that were more labor-intensive than
capital-intensive, contrary to H–O theory
Terms of Trade
• Terms of trade refer to the rate at which the goods of one country is exchanged for the goods of other country. It is measure of
purchasing power of exports of a country in terms of its imports when the exports prices of the country rise relatively compared to the
price of imports, its terms of trade the supposed to improve. the country benefits from 'gains from trade' if it can have larger quantity of
imports in exchange for a given quantity of exports. different concepts of terms of trade have been put forward by Jacob Viner, Gerald
Meier and Dorrance and Taussig.
1. Net Barter terms of trade (NBTT)=Px/Pm
Price of export, price of import
2. Gross Barter Terms of Trade (GBTT)=Qm/Qx
Quantity of import quantity of exports
3. Income terms of trade (ITT)= PxQx/Pm
4. Single factoral terms of trade (Ts)=Px/Pm*Fx
Fx is productivity of exports
5. Double factoral terms of trade (Td)=Px/Pm*Fx/Fm
Fm is productivity of imports
6. Real cost terms of trade (TR)=Px/Pm *Fx*Rx
Rx refers to the disutility of productive resources used in producing exports
7. Utility terms of trade(Tu)=Px/Pm*Fx*Rx*u
U stands for utility from imports
• Gains from trade (offer curve) Gains from Trade (offer curve)
• An offer curve is a locus of various combinations of the two commodities say X and Y which nation finds acceptable in trade. The offer
curve shows the bargaining position of the country that is how much it is willing to offer of its exports for different quantities of imports.
 Meaning and structure of Balance of Payment
• According to Charles Kindleberger, "the BoP of a country is systematic
recording of all Economic transaction between residents of that
country and the rest of world during a given period of time."
• If the receipts exceeds payment than a country is said to have
favourable BoP and vice versa.
• The BoP record is maintained in a standard double entry book keeping
method. International transaction enter into record as credit or debit.
The payments received from foreign countries enter as credit and
payments made to other countries as debit.
• The following table shows the elements of BoP
Balance of Payment- structure
• The BoP includes 3 types of accounts:
1) current account
a. Trade account
B. Service account
C. Unilateral transfers.

2) capital account

3) official reserves account

A. Foreign exchange
B. Gold
C. Special drawing rights.
 Components of current account
• The current account measures the flow of goods, service and income which occur across the national borders it
includes following item :
A. Balance of Trade
Which includes export and imports of goods. It is also called the balance of visible trade. Balance of trade is the
difference between export and import of goods. It is not necessary for balance of trade to be always in balance. If a
country's export is more than import there is a trade surplus hence the country has a favourable BoP and vice versa.
 
B. Balance of invisible trade (services)
Which includes the export and import of service. The services includes the following, services refers to receipts from
tourism , transportation, engineering, business service fees (from lawyers or management consulting and royalties
from patents and copyrights)
 
C. Unilateral transfers
these transfers are one way transaction. As there is no claim involved so far as repayment is concerned. Unilateral
transfers includes gift, grant and personal remittances (salaries sent back to their families in their country). Which are
salary sent back into home country of a national working abroad receipts from income-generating assets such as
stocks (in the form of dividends) and also interest payments on external debt.
• The capital account measures the outflow and inflow of capital into the economy the capital account
includes the following capital transaction.
• Long term movements of capital:
• this includes
1)portfolio investment: which refers to the purchase of long term securities by foreigners from the residence of
the domestic countries.
•  
2) direct investment :
• Which refers to the foreign investment in plant and machinery in the country for doing business. In this
case the investor has controlling power.
• Short term movement of capital:
This includes purchase of short government and corporate securities with maturity period of less than 1 year.
For example commercial papers and treasury bills.
• Loan repayments
(Loan from IMF international agencies, etc)
All the capital inflow are recorded as positive entry in BoP and outflow as negative entry.
• 3) Official Reserve Account:
• A) foreign currency
• B) gold
• C) SDRs
• The position of international reserves account determine the foreign
exchange reserve which are available for settling the deficit in current
or capital account of the Country.
• Current Account + Capital Account = change in official reserve account
 Conclusion
• Autonomous and accommodating transaction
• Autonomous items refer to those international transactions which take
place due to some economic motive such as profit maximisation.
• Autonomous transaction are independent of other items in BoP
account for e.g. imports and exports.

• Accommodating transactions are those transactions that are

undertaken for the specific purpose of equalising the BoP from an
accountant's view. They are not motivated by profit.
 Types of disequilibrium
o Introduction
• To determine whether the BoP is in equilibrium or in disequilibrium, only
autonomous transactions are considered.
• If the total receipts from autonomous transactions are equal to the total
payment from the same. Then there is an equilibrium in BoP.
• If total receipts from this transactions are not equal to the payments then there
is a disequilibrium in BoP. This disequilibrium is either in the form of surplus or
deficit any disequilibrium in the BoP is offset by the accommodating
transactions.
• Thus theoretically speaking from accountants perspective BoP always balances.
Yet there exists disequilibrium in the BoP from an economist point of view.
 Types of disequilibrium
1) structural disequilibrium: this is caused by structural change in the Economy, affecting the
demand and supply relations in commodity and factor markets. some of the structural
disequilibrium is as follows:
A) a shift in the demand due to changes in tastes, income, fashions, etc. Would decrease or
increase the demand for imported goods thereby causing a disequilibrium in BoP.
B) if foreign demand for a country's product declines due to new and cheaper substitutes from
abroad then the country's exports will decline causing a deficit.
C) changes in the rate of international capital movements may also cause structural
disequilibrium.
D) if supply is affected due to crop failure, Shortage of raw material, strikes, political instability,
etc then there would be deficit in BoP.
E) a war or natural calamities also result in structural changes which may affect not only goods
but also factor of production causing disequilibrium in BoP.
F) institutional changes that take place within and outside the country may result in BoP
disequilibrium for example if a trading block imposes additional import duties on products
imported in member countries of the block, then the exports of exporting country would be
restricted or reduced. This may worsen the BoP position of exporting country.
2) Cyclical disequilibrium:
Economic activities are subject to business cycle, which normally have four phases
boom /prosperity, recession, depression and recovery. during boom period,
imports may increase considerably due to increase in demand for imported
goods. During recession and depression, imports may be reduced due to fall in
demand on account of reduced income. During recession exports may increase
due to fall in prices. During boom period, a country may face deficit in BoP on
account of increased imports.
• Cyclical disequilibrium in BoP may occur because
A) trade cycle follow different paths and different countries.
B) income elasticities of demand for imports in different countries are not identical.
C) price elasticities of demand for imports differ in different countries.
3.short run disequilibrium
This disequilibrium occurs for a short period of 1 or 2 years such BoP disequilibrium arises due to
unexpected contingencies like failure of rains or unfavourable monsoons, strikes, industrial peace
or unrest, etc. Imports may increase and exports may decrease.
International borrowings or lending for a short period would cause short run disequilibrium in BoP of
a country. Short term disequilibrium can be corrected through short term borrowings if short term
disequilibrium occurs repeatedly it may pave way for long run disequilibrium.
4. Long run disequilibrium/Secular disequilibrium
Long run / fundamental disequilibrium refers to a persistent deficit or surplus in the BoP of a country,
it is also known as secular disequilibrium. The fundamental disequilibrium is coined by the IMF for
the countries facing persistent deficit in their BoP. The cause of long run disequilibrium are
A) continuous increase in demand for imports due to increasing population.
B) frequent price changes mostly inflation which affects exports on continuous basis.
C) decline in demand for exports due to technological improvements in importing countries and thus,
the importing countries depend less on imports.
The long run disequilibrium can be corrected by making constant efforts to increase exports and to
reduce imports. IMF suggests macroeconomic reforms for the countries facing fundamental
disequilibrium.
5.Monetary disequilibrium:
It takes place on account of inflation or deflation. Due to inflation prices of
product in domestic market rises which makes export expensive, such a
situation may affect BoP equilibrium. Inflation also results in increase in
money income with people which in turn may increase demand for
imported goods. As a result imports may turn BoP position in
disequilibrium.
Monetary measures to correct disequilibrium in BoP
• Expenditure Switching and Expenditure Reducing
• The principle involved in the measures adopted to correct disequilibrium is to increase exports and earn more than
what we pay for our imports. For this purpose the measures aim at reducing imports while at the same time
promoting exports. To achieve this task a country is required to make export cheap and import costly.
Measures adopted to correct disequilibrium are broadly discussed under A) monetary measures
a) devaluation
b) depreciation
c) deflation
 
a) Devaluation-Expenditure Switching
• It aims at influencing the prices of only traded goods and not the general price level as in case of deflation.
Devaluation refers to an official announcement or an act of monetary authority through which the exchange rate is
changed i. e. The value of domestic currency is reduced vis-a-vis foreign currency.
• For e.g. if the exchange rate is Rs. 50=$1, the decision to devalue currency by 20% will make new exchange rate, Rs.
60= $1. Devaluation makes exports cheaper and imports costlier.

• Marshall and Lerner's condition: if sum of price elasticity of exports and price elasticity of import is
greater than 1, then devaluation will succeed in improving the BoP.
• Depreciation
• Like devaluation lowers the value of domestic currency or increase the value of
foreign currency. Depreciation of a currency takes place in free or competitive
foreign exchange market. Due to market forces.
• An existing rate say, Rs. 60 =$1 may depreciate to Rs. 65 or more.

•Devaluation and Depreciation

• Devaluation and Depreciation have the same effect on exchange rate, though the
former takes place under the fixed exchange rate. Devaluation usually is larger in
degree than depreciation.
•  
• the above method results in expenditure Switching that is people switch or divert
the expenditure from imported goods to the goods of the country, Which devalued
its currency or whose currency is depreciated, as domestic goods are now cheaper
than the imported goods.
 Reduction in absorption- deflation expenditure
adjustment
• 1. Deflation refers to the process of decline in general price level. It was
adopted under Gold Standard. It leads to expenditure adjustment i.e.
people in that country spend money mainly on domestic goods and
service and less on imports .
• 2. Deflation measures of correcting disequilibrium is unpopular as it has
many negative Economic effect as less investment, more
unemployment, less income and consumption and finally less saving
leading to cumulative downward cyclical phase (recession).

• 3. Therefore, deflation as a measure to correct disequilibrium is given

up by almost all countries.
 Non-Monetary Measures
(Direct OR trade measures/ Direct controls)
• Intro: A deficit along with monetary measures may adopt the following non-monetary measure too,
which will either restrict imports or promote exports.
1. Tariffs: are broadly defined as scheduled of custom duties, which includes import duties, export
duties and transit duties. Tariffs are the duties (taxes) imposed on imports. When tariffs are imposed
the prices of imports would increase to the extend of tariff. The increased prices will reduce the dd
for imported goods and at the same time, induce domestic producer to produce more of import
substitutes. Non-essential imports can ve drastically reduced by imposing a very high rate of tariffs.
2. Import Quota Under this method, Government fixes quota of imports. To reduce imports for
correcting the deficit in BoP the Government may introduce restriction on the quantity or volume of
goods imported. Quotas may be of different types
A. The tariff or custom quota
B. The unilateral quota
C. The bilateral quota
D. Moving quota and import licensing.
3. Export promotion: As pointed out earlier the real solution for the deficit in the BoPs lies in
exporting more than imports. If the export sector is not strong, then special efforts are
required to devise special policy measures to promote exports. Some of important incentives
that the government usually offers are : subsidies, tax concessions, grants and other
monetary or Non-Monetary incentive .Exports may be encouraged by reducing or abolishing
exports duties, providing export subsidy, encouraging export production and export
marketing by offering monetary, fiscal, physical and institutional incentives and facilities.
 
5. Import Control imports may be control by imposing or changing import duties, restricting
importing through import quotas and licensing and even by prohibiting altogether the import
of certain inessential items.
6. Import substitution: along with increase in exports, it is necessary to reduce the dependence
on imports. In a highly interdependent world which works under the concept of global
economy it is not possible to reduce imports to greater extent. Besides it is not possible for
every country to think of only exports and not of imports.
• Industries which produces import substitutes require special attention in for of various
concessions, technical assistance, subsidies providing scarce inputs, etc.
It is the day-to-day rate of exchange.
Speculators
• Speculators are agents who speculate, i. e. purchase and sell foreign
exchange with the intention of making a profit by taking the advantage
of changes in exchange rates. They participate in the forward
exchange market by entering into forward exchange deal. They do so
on the basis of their own calculation of the difference between the
forward rate and the spot rate that may prevail on a future date. For
example if a speculator enters to sell a dollar at rupees 66.00 after
three months with expectations of the dollar becoming cheap and the
spot rate after three months is rupees 65, the speculator purchases
the dollar for spot rate rupees 65=dollar 1 and sells for the agreed
forward rate rupees 66, thus making a profit of rupees 1. He may incur
loss if the spot rate crosses rupees 67.
Arbitrage means the simultaneous buying and selling of foreign currencies with the intension of making profit.
Arbitrage takes place because of
Difference in bid and ask price at different banks, &
Difference in exchange rate at different places
• Example
• Suppose the market for $ in the UK is: £1 =
$2.01
• and in Japan £1 = $2.01
• If there was a sudden increase in demand for
sterling in the UK. The £ would rise in the UK
£1=$2.10. If markets are not perfectly
competitive there may be a lag effect so that
£ are cheaper in Japan (stay at £1 = $2.01).
Therefore you could buy £in Japan and then
immediately sell them in UK markets. This
would give you a small but guaranteed profit.
As arbitrageurs do this it will help bring the
two markets into line. The speed with which
markets are brought into line depends upon
how many people seek to do this.
 Flexible Exchange rate
• Flexible exchange rate system exists when countries of the world
switch over to inconvertible paper currency standard. Under this form
of foreign exchange rate system the foreign exchange rate is
determined freely by the twin market fares of demand for and supply
of foreign exchange in the foreign exchange market. The foreign
exchange rate goes on fluctuating as per the fluctuations in the
demand for and supply of foreign exchange under this system the
foreign exchange rates are allowed to fluctuate freely.
 Managed Exchange Rate:
• Under the managed exchange rate, floating exchange rates are ‘managed’ partially. That is to say, exchange
rates are determined in the main by market forces, but central bank intervenes to stabilise fluctuations in
exchange rates so as to bring ‘orderly’ conditions in the market or to maintain the desired exchange rate
values.
• Managed flexibility means the system of controlled flexibility to foreign exchange rate. The system of
managed flexibility is a golden mean, a via media between the two extreme situations of foreign exchange
rate systems viz.
• i) the fixed exchange rate system and
• ii) the flexible exchange rate system.
• As a matter of fact the system of managed flexibility emerged out of the drawbacks of both the foreign
exchange rate systems. In the managed flexibility the Govt. is called upon to play a very important role of
intervening in the foreign exchange market. The central bank of the country being the monetary and
foreign exchange authority of the country intervenes into the foreign exchange market. As per the
managed flexibility the foreign exchange rate is allowed to fluctuate but within limit. Hence it is also called
as controlled flexibility. When the demand for foreign exchange rises the central bank release and sells
domestic currency and buys foreign currency to tide over the increased demand for foreign exchange.
Conversely when the supply of foreign exchange rises it buys domestic currency and sells foreign
currency. Thus the central bank keeps the fluctuations in the foreign exchange rate within limit.
 
• The managed flexibility can be of three types.
• i) Adjustable Peg System
• ii) Crawling Peg System
• iii) Managed floating. An adjustable peg is an exchange rate policy in which a
currency is pegged or fixed to a major currency such as the U.S. dollar
or euro, but which can be readjusted to account for changing market conditions
or macroeconomic trends. An example of managed currency or “dirty float”,
these periodic adjustments are usually intended to improve the country's
competitive position in the export market and world financial stage.
• A crawling peg is a system of exchange rate adjustments in which a currency with
a fixed exchange rate is allowed to fluctuate within a narrow band of rates. 
• A managed floating exchange rate is a regime that allows an issuing central bank
to intervene regularly in FX markets in order to change the direction of the
currency's float and shore up its balance of payments in excessively volatile
periods. This regime is also known as a “dirty float”.
 Merits and demerits
Fixed Exchange Rate
Fixed exchange rate system A fixed exchange rate occurs when a country tries to keep the value of its currency at a
certain level against another currency this makes clear that a country is able to defend its currency by the buying and
selling of foreign currencies.
• Advantages
1. Exchange rate stability If the exchange rate is unstable or variable the exporters will not be certain about the price they
would receive for the goods to be expedited by them; the importers will not be certain about the price and the
payment they have to make for their imports. These uncertainties involve risk for exporters and importers. This
greatly harms the growth of world trade. Thus, the chief merit of fixed exchange rate is that it eliminates the
possibilities of such uncertainties and associated risk and thereby promote foreign trade.
2.Promotes capital movement A stable currency does not involve any uncertainties about capital loss on account of
exchange in exchange rate. Therefore, fixed rate system would attract foreign capital investments. It encourages long
term capital flows in an orderly and smooth manner.
3. No dear of currency fluctuation: there is no fear of currency depreciation or appreciation under a system of fixed
exchange rate system. It creates confidence in the strength of domestic currency.
4. No adverse effect of speculation: there is no fear of any adverse effect of speculation on the exchange rates, as
speculative activities are controlled and prevented by the monetary authorities under a regime of fixed exchange rate.
5. For small countries which are dependent on foreign trade stability in the exchange rate plays an important role.
6. It shields economy from the occurrence in the other countries, it is to prevent any impact of inflation.
• Disadvantages
1. Comparative advantage unclear: under this system, comparative advantage of a
country is not clear. For instance the exchange rate may be so low that a product
may seem to be very cheap to the other country. Consequently, the country may
export that commodity in which it has no comparative advantage along with a very
high exchange rate.
2. Problem of international liquidity: to expand its trade a country must have
adequate international liquidity. To maintain a fixed exchange rate the country
must have sufficient reserves of foreign currency to avoid balance of payments
disequilibrium. On the other hand excessive international liquidity is also not good
for the country.
3. Borrowing from International institutions : World Bank, IMF
4. Aggravates fiscal deficit.
 Merits and demerits
Flexible Exchange Rate
• Merits
1. Independent monetary policy
• Under the floating exchange rate system the balance of payments deficit of a country can be rectified by
changing the external price of the currency. On the country if a fixed exchange rate policy is adopted, then
reducing a deficit could involve a general deflationary policy for the whole economy, resulting in
unpleasant consequences such as unemployment and idle capacity.
• Thus, a floating exchange rate allows a government to pursue internal policy objectives such as full
employment growth in the absence of demand-pull inflation without external con­straints (such as debt
burden or shortage of foreign exchange).

2. Problems of Undervaluation and Overvaluation are Avoided

3. Promotes Growth of Multilateral Trade
4. Automatic solutions to balance of payments
5. Increase in international liquidity
6. No burden of maintaining adequate level of foreign exchange as in case of fixed exchange rate system.
 Demerits
• Low import and export elasticities doesn’t allows this system to operate successfully,
infact depreciation of the weak currency will simply tend to worsen the BoPs deficit
further.
• Unstable conditions reduces international trade (for a trader payments to be made
and received is uncertain) and also FDI and FPI gets affected.
• Speculative activities leads to unnecessary capital movements
• Imports inflation, as in if imported goods’ prices are high and elasticity of dement for
imports is inelastic, there will be inflation in home country.
• Provides an Inflationary Bias to an Economy
In case of BoP deficit, there is depreciation of currency which makes imports costlier, thus
cost push inflation.
• Thus, we see a mixture of both exchange rate system known as managed exchange
regime.
What is Foreign Direct Investment and
Foreign Portfolio Investment
• Foreign direct investment (FDI) is where an individual or business from one nation, invests in
another. This could be to start a new business or invest in an existing foreign owned
business. For instance, Mr Bloggs from the US has $1 million and wants to start a new
company in Germany. He invests this, creating a new clothing manufacturing firm in the
country. This would classify as a FDI.
• However, the definition is slightly different when it comes to investing in a foreign companies
assets. According to the IMF, a foreign direct investment is where the investor purchases
over a 10 percent stake in the company. FDI gives investor management right of the
company. It can be investment by multinationals.
• Anything under this amount is classed as part of a ‘stock portfolio’. For instance, this covers
the small amount of stocks that the average citizen may have invested. Essentially, anything
too small to influence any level of control of the firm.
• Portfolio investment is the investment in Financial instruments. It bridges the gap between savings
and investment, provides us foreign exchange and promotes economic development. It does not gives
any control over company to the investors.
 • Types of Foreign Direct Investment (FDI)
• Horizontal FDI
• Horizontal FDI is where funds are invested abroad in the same industry. In other words, a business invests in a
foreign firm that produces similar goods. For instance Nike, a US based firm, may purchase Puma, a Germany
based firm. They are both in the industry of sportswear and therefore would be classified as a form of horizontal
FDI.
• Vertical FDI is where an investment is made within the supply chain, but not directly in the same industry. In
other words, a business invests in a foreign firm that it may supply or sell too.
• For instance, Hershey's, a US chocolate manufacturer, may look to invest in cocoa producers in Brazil. This is
known as backwards vertical integration because the firm is purchasing a supplier, or potential supplier, in the
supply chain.
• We then have forwards vertical integration. So this is where a firm invests in a foreign company that is further
along in the supply chain. For instance, Hersheys may look to purchase a share in Alibaba; where it sells its
products.
• Conglomerate FDI
• Conglomerate FDI is where an investment is made in a completely different industry. In other words, it is not
linked in any direct way to the investors business. For instance, Walmart, a US retailer, may invest in BMW, a
German automobile manufacturer.
• This may seem strange to some but offers big businesses an opportunity to expand and diversify into new
areas. To explain, some big businesses come to a point where the demand for its fundamental business starts
to decline. In order to survive, it must invest in new ventures. Even big businesses with strong demand may
look to new industries where growth and return on investment are significantly larger.
Benefits of Foreign Direct Investment
• 1. Boost to International Trade

• Foreign direct investment promotes international trade as it allows production to flow to parts of the world which are more cost effective. For
instance, Apple was able to conduct FDI into China to assist with the manufacturing of its products However, many of the components are also
shipped in from elsewhere, generally from the region of Asia. For instance, the camera is made by Sony, which sources its manufacturing in 
Taiwan. There is also the case of the flash memory, which is sourced by Toshiba in Japan. We also have the touch ID sensor which is made in
Taiwan, and the chipsets and processors, which are made by Samsung in South Korea and Taiwan. These are but a small handful of the
components, but demonstrate how inter-connected the supply chain has become between countries. Both Samsung And Song have conducted
investment in the likes of Taiwan, China, and Japan. As a result, it has created new jobs in the region and boosted trade between the nations.

• 2. Reduced Regional and Global Tensions

• As we have seen with the Apple example, a supply chain is created between countries. In part, this is created by the division of labour. For
instance, South Korea may make the batteries, Taiwan the ID sensors, and Japan the cameras. As a result, they are all dependent on each other.
If there is a revolt in Taiwan, the whole process could fall apart. Without the ID sensors, the final product cannot be made, so the need for other
components is also reduced. This means workers in Japan and South Korea are also affected. As a result of this interconnected supply chain, it
is in the interest of all parties to ensure the stability of its trading partners. So FDI can create a level of dependency between countries, which in
turn can create a level of peace. To use a famous metaphor, you don’t bite the hand that feeds you. In other words, if nations are reliant on each
other for their income, then the likelihood of war is also reduced.
• 3. Sharing of Technology, Knowledge, and Culture

Foreign direct investment allows the transfer of technology, knowledge, and culture. For instance, when a firm from the US invests in another from India, it has a
say in how the firm is run. It is in its interest to ensure the most efficient use of its resources. What happens as a result is that useful techniques or ways of
conducting business are transferred. The members of the US company may say, have you tried doing A, B, and C? By coming in from a different cultural
background and perspective, often, efficiencies can be achieved. Furthermore, there is the case of technology. It can transfer over in a number of ways. First of all,
employees benefit from having first-hand access to the new technology. They may then be able to use this to start their own ventures. Second of all, the technology
could be outright purchased from a foreign nation. For instance, copyright technology could be sold from Company A in the US to Company B in India. Finally,
the technology could be reverse-engineered or provide inspiration for domestic development.

• 4. Diversification

From the businesses perspective, foreign direct investment reduces risk through diversification. By investing in other nations, it spreads the companies exposure.
In other words, it is not so reliant on Country A. For instance, Target derives its entire revenues from the US. Should an economic recession hit Stateside, it’s
almost guaranteed to harm its profits. By diversifying and investing in foreign markets, it allows businesses to reduce domestic exposure. So if a US firm invests in
new stores in Germany, the level of risk is reduced. This is because it is not reliant on one market. Whilst there may be a decline in demand for one, there may be
growth in another. To use an analogy, it’s similar to placing a bet in roulette on both red and black.

• 5. Lower Costs and Increased Efficiency/ Better resource allocation

Foreign direct investments can benefit from lower labour costs. Often, businesses will off-shore production to nations abroad that offer cheaper labour. Now there
is an ethical element to this than is often debated, but we will leave that aside for now. Whether it is ethical or not is irrelevant as it is a benefit to the business.
Although labor costs are lower, we must also consider productivity. For instance, one person in China may produce one unit for $1 an hour. However, an employee
in the US may be able to produce 20 units for $10 an hour. So whilst a Chinese employee is cheaper, they only make 1 unit per $1, compared to 2 units per $1 in
the US. With that said, foreign direct investors will take such factors into account. And in most cases, the labour is so much cheaper than most of the productivity
differentials are eliminated. This means the investment is cost-effective. In other words, more employees will be needed to make the same number of goods, but
the total cost to produce is lower. On most occasions, foreign direct investment will result in a net gain for the company. After all, it is in their interest to ensure the
investment pays off. However, there are exceptions, where FDI can in fact go the other way. Nevertheless, on the whole, FDI is generally associated with lower
costs and increased cost-effectiveness.
• 6. Tax Incentives

• Reduced levels of corporation tax can save big businesses billions each and every year. This is why big firms such as
Apple use sophisticated techniques to off-shore money in international subsidiaries.

• Countries with lower tax regimes are usually those that are favoured. Examples include Switzerland, Monaco, and
Ireland, among others.

• Furthermore, there are also tax incentives by which the foreign government offers tax breaks to investors in a bid to
encourage FDI.

• 7. Employment and Economic Boost

• When money is invested in another country, it creates jobs, new companies, and new factories/buildings. This brings
about new opportunities for local residents and can stimulate further growth.

• With greater levels of employment being made available, it creates a greater level of purchasing power in the wider
economy. If we couple this with the fact that big corporations often pay above the average to attract the best workers, we
can see a spill-over effect.

• With employees earning more money, they also create demand for other goods in the economy. In turn, this stimulates
employment in other markets and industries.
Disadvantages of Foreign Direct
Investment
1. Foreign Control
One of the main fears, particularly among developing nations, is that they can essentially be brought and controlled by foreign powers.
Land, labor, and capital are relatively cheap in countries such as Vietnam or Taiwan. Therefore the US or other developed nations can
come in with significant sums and buy up vast sums of the country.
This is why some countries place strict restrictions on FDI. Often, investors must join a partnership with a local business in order to
enter. This way there is still a level of domestic control
2. Loss of Domestic Jobs
When significant sums of money are transferred to another, it is an investment that would have been used in the home market.
Consequently, FDI may boost employment in foreign nations, but may temporarily reduce it at home.
Instead of the funds being invested in new factories and creating jobs, it is sent abroad instead.
As we have seen in the US, manufacturing jobs have been lost to the likes of Mexico, which can manufacture motor vehicles at a lower
cost. Whilst this provides cheaper goods for the consumer, it can come at the cost of domestic jobs.
3. Risk of Political or Economic Change
When investing abroad, particularly in developing nations, there is huge risk that is associated. For instance, there may be huge
political upheaval, or a regional war. This may consist of a new government that is not so favourable to investors.
Consequently, there is an element of significant risk. With that said, those countries and regions that have been marred with instability
are usually the last to be considered for investment. We only need to look at the Middle East and Africa as examples.
Nevertheless, even in many Asian countries, there is a possibility of the unknown. With rising tensions between China and Japan,
there are risks of conflict as well as political uncertainty. All of which present a higher risk.
MNCs/TNCs
Multinational corporations or MNCs have been playing a dominant role globally and have been integrating the world economy. However, their role and contribution to the process of growth
and development of less developed regions are of controversial. MNCs have therefore evoked passions of an extreme nationalistic variety across the political spectrum. A multinational
corporation that has its facilities and other assets in at least one country other than its home country. Such companies have offices and/or factories in different countries and usually have a
centralized head office where they co-ordinate global management. Very large multinationals have budgets that exceed those of many small countries. MNCs are now officially designated by
the UN as Transnational corporations or TNCs. Nearly all major multinationals are American , Japanese or west European. Examples include Nike, Coca cola, Walmart, AOL, Toshiba, Honda and
BMW.

Multinationals in India: There are many multinationals operating in India since the British period. Most of the MNCs concentrated in the production of consumer goods. Multinationals in India,
as in other developing countries have advantages and disadvantages as stated below:

Role/advantages:

1. Direct employment: the 100 largest TNCs provide employment to 14.3 million persons at home and abroad. Employment on TNCs accounts for nearly 10percent of the world's labour
force.

2. Indirect employment: TNCs also contribute indirectly to employment generation in developing countries through backward linkages such as the purchasing of raw materials, parts and
components from sub-contractors and external suppliers. The importance of these effects has grown in recent years as firms increasingly rely on national and global outsourcing for
technological, cost or flexibility reasons.

3. FDI: the top 100 TNCs control about one third of the world foreign direct investment. More than 40% of MNCs assets are located outside their home countries. MNCs provide
investment that does not have to be financed by local savings, which can be used for building other assets in the country.

4. Technology: MNC capital brings with it up-to-date technology which should be hard to develop domestically or even transfer to home owned firms. Besides the technology may not
be commercially available.

5. Higher income : MNCs provide higher paying jobs than might be available to local inhabitants and thus raise the standard of living.

6. Foreign networking and access to foreign markets: MNCs enable foreign networking by linking the local economy with the world Economy in ways that would be hard to accomplish
by the firms of purely local origin.

7. Skills: MNCs pass on many benefits to the host country which they cannot take away as part of their own income. Benefits such as transfers of general knowledge and of specific
technologies in production and distribution, industrial and upgrading, work experience of the labour force, introduction of modern management and accounting methods,
establishment of finance related and trading networks and upgrading telecommunications services.

8. Competitiveness: MNCs affect the host country's competitiveness by raising the productivity of capital and enable the host country to attract new capital on favourable terms.
10. Industrialization: many small countries could be said to have begun industrialization with MNC investments. Typically, such foreign direct investment begins with the
assembly of components imported from the source country.
11. Contact: MNCs are an important form of contact between more and less developed countries.
12. Higher productivity: firms with foreign equity participation have been found to exhibit much higher levels of productivity.
13. Technology diffusion : MNCs may also provide technology diffusion through labour turnover as domestic employees move from foreign to domestic firms.
14. Wealth creation: MNCs channel physical and financial capital to countries with capital shortages.as a consequence, wealth is created, which yields new jobs directly and
through "crowding-in" effects. Through free market initiatives, MNCs create wealth.
15. Generation of revenue: new tax revenues arise from MNC generated income, allowing developing countries to improve their infrastructure and to strengthen their
human capital.
16. Reduction of poverty and resolution of conflicts: by improving the efficiency with much needed environment friendly technologies. If developing countries desire to
escape severe conditions of poverty, they need to privatize, deregulate, protect private property rights, and establish a rule or law- the MNCs will then provide the capital.
17. Environment friendly technologies
18. Infrastructure: MNCs have helped to build up the infrastructure of countries. They fill in the investment gap for much needed infrastructure.
Disadvantages:
1. Monopoly power: some MNCs are larger and often more powerful than the countries they invest in and therefore seek to control policies in their favour.
2. Limited skill development
3. Profits repatriated in foreign exchange: profits of MNCs are repatriated in foreign exchange usually. American dollars that developing countries cannot afford to lose.
4. Environmental damage : MNCs work with lower standards for labour and environment in developing countries.
5. Loss of revenue: very often they bargain for advantages in terms of tax rebates and tax holidays thus depriving the governments of developing countries of mic needed
revenue. The repatriated profits become a part of the developed nation's national income.
6. Exploitation: MNCs secure access to cheap labour and raw materials from LDCs and boost their own profits.
7. Inappropriate techniques of production and products: MNCs have been criticised for using capital intensive techniques in countries that are labour abundant and for
mass consumption.
Free Vs Protection
Countries trade with each other by adopting certain types of trade policy. Broadly, trade policy can be categorised as free trade or restricted trade, also
known as protection. They are also termed as outward looking policy or inward looking policy. The world never had a completely free trade, that is trade
without any restriction. Therefore we could say that countries either follow a liberal trade (free trade) or restricted trade (protection). The type of trade
policy that a country follows depends on a number of factors or its economic problems.
ARGUMENTS FOR FREE TRADE
1. More equal distribution of resources: The unequal distribution of resources (natural resource, physical and human capital) prevents countries from
producing everything their citizens need and/or want. This is why countries trade. Trading benefits both countries with abundant resources and countries
with few resources.
2. Increased standard of living: International trade reduces the cost of goods and hence it raises the standard of living. Most traded products are
manufactures and are subject to greater productivity growth (and hence steeper declines in costs and prices), Free trade boosts the standard of living by
offering consumers the widest variety and the highest quality at the lowest possible prices
3. Availability of variety of goods: Goods produced in different countries are not exactly the same international trade allows us to choose from a wider
range of goods than would otherwise be available for example, in America they can choose between Japanese and German cars in addition to
American, in India we can have Chilean apples and Washington apples in addition to Kashmir apples
4. Efficiency: Efficiency means that the cost of production in terms of labour, capital and other inputs is reduced as the goods are produced in the most
efficient way. Free trade allows nations to efficiently utilize resources and specialize in producing a limited number of goods while consuming a greater
variety of goods. Free trade increases competitive pressures that force the efficient use of a nation's resources.
5. Lower costs through economies of scale: Some goods can be produced at a low cost only if they are produced in large quantities - a phenomenon
called economies of scale. A firm in a small country cannot take full advantage of economies of scale if it can sell only in a small domestic market. Free
trade gives firms access to larger world markets and allows them to realize economies of scale more fully.
6. Increased competition: A company shielded from foreign competition is more likely to have market power which in turn gives it the ability to raise
prices above competitive levels. This is a type of market failure. Opening up trade fosters competition and gives the invisible hand a chance to work.
Vigorous competition prohibits domestic oligopolies from setting prices far above costs. Opening a country's markets to foreign firms tends to reduce the
market power of domestic firms. For example, domestic monopolists are subjected to competitive pressures and they are forced to become more
efficient.
7. Vent for surplus: Free trade not only leads to a greater market but also provides a vent for surplus production in the
economy. Free trade allows countries to specialize in what they do best and to enjoy a wider market for their goods and
services.
8. Diffusion of technology: International trade may also encourage the diffusion of technology by increasing the commercial
contacts between employees in firms from different countries. Such interactions serve to transfer information about new
products and production processes Licensing is a common practice that allows the international transfer of technology. In
addition, technology is embodied in new capital equipment. Thus, freer international trade facilitates the transfer of technology
internationally and furthers economic growth.
9. Enhanced flow and exchange of ideas: The transfer of technological advances around the world is often thought to be linked
to international trade in the goods that embody those advances. The best way for a poor agricultural nation to learn about the
computer revolution is, for instance, is to buy some computers from abroad rather than trying to make them domestically.
10. Greater investment: Free trade leads to greater investment and consequently increased employment, income and
consumption and therefore growth in the economy. Especially given the spread of technology by means of investment and
exposure to new goods.
11. Increased productivity: Productivity increases either because firms are compelled to become more efficient, or the least
productive firms are forced to close, thus raising the average level of productivity for the economy as a whole.
By providing competitive forces and incentives for productivity and innovation, international trade has accelerated the process
of "creative destruction by which outdated and productive activities are replaced by new technologies and more dynamic
enterprises. Secondly, productivity in the industry increases as more resources are utilised efficiently.
Protection
• The free trade economic policy contrasts with protectionism, or the fostering of domestic industrial or agricultural production by means of import tariffs or other
legal obstacles to the movement of goods across frontiers.
• One of the most popularly quoted theoretical arguments for protection is in terms of the Stolper-Samuelson theorem. The Stolper-Samuelson theorem states that
free international trade benefits a country's abundant resource and harms that country's scarce resource, Consider the example of China and Japan. Prior to free
trade, labour in Japan is relatively scarce and, thus, wages tend to be high. With free trade, the relative scarcity of labour is reduced by the fact that Japanese
consumers can buy the labour-intensive good at a lower price from China. Thus, there is downward pressure on the price of labour in Japan Similar reasoning can be
applied to explain why capital in Japan benefits from free trade.
• Forms of Protection:
• Restricted trade policy (or trade restrictions or barriers) take three common forms-import quotas, voluntary export restraints and tariffs.
• 1 Tariff: A common trade policy is tariff. In international trade a tariff is a tax levied on commodity when it crosses a national boundary. The most common tariff is the
import duty, that is, a tax imposed on imported goods. Some countries, usually exporters of agricultural commodities and raw materials also impose export taxes.
• 2 Import Quota: An import quota refers to the limit on the quantity of good produced abroad that can be imported.
• *Voluntary Export Restraint: A voluntary export restraint is a self imposed limitation on the number of products that are shipped to a particular country. Under a
voluntary export restraint a country voluntarily decreases its exports in an attempt to reduce chances that the importing country will set up trade barriers.
• 4 Other barriers: Governments sometimes use less formal methods to limit imports For instances
• (A) Licensing: Foreign companies need to have licenses (which are not granted easily) to sell their goods.
• (B) Health and safety regulations/requirements: Such regulations are subtle trade barriers e.g. ban on imports of fruits/vegetables treated with particular
insecticides.
• Restrictive trade policies are common throughout the world although they are sometimes disguised. For example, the United States government has sometimes
pressured Japanese automakers to reduce the number of cars they sell in the United States. These so-called "voluntary export restriction are not really and, in
essence, are a form of import.
 ARGUMENTS FOR PROTECTION
1. The infant industry argument: If developing countries have industries that are relatively new, then these industries would struggle against international competition,
though in the future they may be able to gain comparative advantage. This shows that comparative advantage can change over time. Therefore protection would
allow them to progress and gain experience to enable them to be able to compete in the future.
New industries sometimes argue for temporary trade restrictions to help/protect new/infant industries. New industries need time and practice to become efficient
producers. After a period of protection the argument goes, these industries will mature i.e. produce efficiently at a competitive price and be able to compete with the
foreign firms Similarly, older industries argue that they need temporary protection to help them adjust to new condition
However, it is difficult for the government to
 (A) Decide which industries will eventually be profitable and also to
(b)Decide whether the benefits of establishing these exceeds the costs of protection to consumers
The temporary policy is often hard to remove - i.e., the infant may ever grow up as the protected industry lacks the incentive to become more efficient and
competitive.
2 Large trade and current account deficits: One concern about free trade is that it has given rise to large trade and current account deficits which add to the nation's
debt and put its future prosperity at risk This is because one cannot foresee when the deficit will stop growing and return to more sustainable levels, or through what
mechanisms this adjustment will occur, or whether this adjustment will be smooth or disruptive for financial markets and the economy in general. No matter how a
correction of the external imbalance proceeds, it will involve a range of adjustments to investment, saving, and asset price. Both for the economy and its trading
partners.
3. The employment argument Beggar-my-neighbour policy: According to this argument governments should regulate trade in order to protect certain industries and
jobs from foreign competition. Opponents of free trade argue that trade with other countries destroys domestic jobs, e.g., free trade in commodity X will cause the
price of commodity X to fall, that would mean a fall in the quantity of commodity X produced in the economy and thus a reduction in employment in the industry.
Protection is often urged as a means of increasing employment. With imports reduced, demand for domestic substitutes will be stimulated, expanding production at
home. Economists call this a "beggar-my neighbour" policy, in other words, the improvement of employment at home is achieved entirely at the expense of
employment elsewhere. The limitation of such a practice is that it invites retaliation from other nations suffering from problems of unemployment.
4. The national security argument: Certain industries might need protection from foreign competition because their products are essential to defending the country.
Free trade implies that a country becomes dependent on another to supply certain goods. e.g. steel. If a war broke out and foreign supply is interrupted a country
may not be able to produce enough steel and weapons to defend itself.
5. The protection-as-bargaining-chip argument: Many policy makers claim to support free trade but, at the same time, argue that trade restrictions can be useful
when we bargain with our trading partners They claim that the threat of a trade restriction can help remove a trade restriction already imposed by a foreign
government. e.g. country X can threaten to impose a tariff on steel unless country Y removes its tariff on wheat. If country Y responds by removing its tariff on wheat
the result is freer trade.
6. Retaliation or protection against dumping: Dumping occurs when products are made available as imports at prices lower than the prices prevailing in the exporting
country. The argument is that a domestic firm cannot compete against a foreign firm that sells at a loss. The foreign firm does that to get an entry into the market and
once established will raise its price to profitable levels. In the interim period the domestic firm can be protected by tariffs or import quotas. An example of dumping is
when the EU sold a lot of its food surplus at very low prices on the world market. This caused problems for world farmers because they saw a big fall in their market
prices.
7. The unfair competition argument or duties to offset subsidies: If a foreign firm is selling below cost it can also mean that the government is subsidizing it in an effort to
obtain more foreign exchange. The argument is that free trade is desirable only if all countries play by the same rules. If firms in different countries are subject to
different laws and regulations then it is unfair to expect the firms to compete in the international market, e.g., if the government of country A subsidizes its steel
production then the steel producer in country B might argue that it should be protected.
8. Terms of trade for commodities: If a country does not use tariffs to protect its newly formed high-tech industries it might be doomed to producing only those goods
based on favourable raw materials or climate (e.g., mining or agricultural commodities), or times such as inexpensive clothes or toys. Over the long run, the terms of
trade (relative price of exports to imports) will shift against such items, and the country will remain poor. Such a country will seek to develop the industrial capacity for
goods and services by initially imposing tariffs on manufacturing goods in which case the infant industry argument applies
9. Diversification: Many developing countries rely on producing primary products where they currently have a comparative advantage. However relying on agricultural
products has several disadvantages. For example: prices can fluctuate due to environmental factors. Secondly, primary products have a low income elasticity of
demand. Therefore, with economic growth demand will only increase a little. Diversification reduces this risk so countries will sometimes introduce tariffs in order to give
other industries a chance to get started.
10. Lower real wages: Though an increase in imports does not harm the overall economy it can have a negative impact on certain sectors. e.g. to the extent that
imported clothing or toys is made by workers with low wage rates it reduces the wage rates of textile or toy factory workers in the domestic economy. Thus, an increase
in imports reduces the real wages and returns to capital in those industries directly affected by higher imports which often leads to intensive efforts to restrict trade.
However, the evidence is particularly unclear. Some studies have suggested that import competition from low-wage countries has depressed wages for low-skilled
workers relative to those for higher. skilled workers in recent decades. Other studies have argued that the rise in skill premiums is due to technological developments
that have raised the demand for educated workers.
11. Raise revenue for the government: In many developing nations where most income is in kind and where cheating is common it may be virtually impossible to collect
revenue from either a sales or income tax. Import taxes can be used to raise money for the government, however this will only be a small amount of money.
12. Environmental Concerns: A fundamental concern is that free trade will stimulate economic growth and that this growth will harm the environment. It is argued that
free trade can harm the environment because LDCs may use up natural reserves of raw materials for export. Also countries with strict pollution controls may find
consumers import the goods from other countries where legislation is lax and pollution allowed. However supporters of free trade would argue that it is up to individual
countries to create environmental legislation.
13. Cultural identity: This is not really an economic argument but more political and cultural. Many countries wish to protect their countries from what they see as an
Americanisation or commercialisation of their countries/culture.
From the above analysis it can be observed that arguments for free trade are arguments against protection. Similarly arguments for protection become arguments
against free trade.