Course Pack – Unit II – IBE

Topics Covered:

International Trade: Theories of international trade (classical theories like absolute advantage,
comparative advantage, etc and modern theories like factor endowment theory, factor price
equalization theorem, export base theory, endogenous growth theory, Product cycle theory and Linder’s
theory of representative demand. World trading environment – Volume, composition and direction of
world trade in goods and services; Government intervention in International Trade: Arguments for
Government intervention; Instruments of Commercial Policy: Tariffs and non tariff measures and their
effects with special reference to India. India’s foreign trade- Volume, composition and direction of trade.

International Trade Theories:

International trade theories are simply different theories to explain international trade.
Trade is the concept of exchanging goods and services between two people or entities.
International trade is then the concept of this exchange between people or entities in two
different countries.

People or entities trade because they believe that they benefit from the exchange. They
may need or want the goods or services. While at the surface, this many sound very
simple, there is a great deal of theory, policy, and business strategy that constitutes
international trade.

In this section, you’ll learn about the different trade theories that have evolved over the
past century and which are most relevant today. Additionally, you’ll explore the factors
that impact international trade and how businesses and governments use these factors to
their respective benefits to promote their interests.

Mercantilism;

Developed in the sixteenth century, mercantilism was one of the earliest efforts to
develop an economic theory. This theory stated that a country’s wealth was determined
by the amount of its gold and silver holdings. In it’s simplest sense, mercantilists believed
that a country should increase its holdings of gold and silver by promoting exports and
discouraging imports. In other words, if people in other countries buy more from you
(exports) than they sell to you (imports), then they have to pay you the difference in gold
and silver. The objective of each country was to have a trade surplus, or a situation where
the value of exports are greater than the value of imports, and to avoid a trade deficit, or a
situation where the value of imports is greater than the value of exports.
A closer look at world history from the 1500s to the late 1800s helps explain why
mercantilism flourished. The 1500s marked the rise of new nation-states, whose rulers
wanted to strengthen their nations by building larger armies and national institutions. By
increasing exports and trade, these rulers were able to amass more gold and wealth for
their countries. One way that many of these new nations promoted exports was to impose
restrictions on imports. This strategy is called protectionism and is still used today.

Absolute Cost theory,

In 1776, Adam Smith questioned the leading mercantile theory of the time in The Wealth
of Nations.Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations
(London: W. Strahan and T. Cadell, 1776). Recent versions have been edited by scholars
and economists. Smith offered a new trade theory called absolute advantage, which
focused on the ability of a country to produce a good more efficiently than another
nation. Smith reasoned that trade between countries shouldn’t be regulated or restricted
by government policy or intervention. He stated that trade should flow naturally
according to market forces. In a hypothetical two-country world, if Country A could
produce a good cheaper or faster (or both) than Country B, then Country A had the
advantage and could focus on specializing on producing that good. Similarly, if Country
B was better at producing another good, it could focus on specialization as well. By
specialization, countries would generate efficiencies, because their labor force would
become more skilled by doing the same tasks. Production would also become more
efficient, because there would be an incentive to create faster and better production
methods to increase the specialization.

Smith’s theory reasoned that with increased efficiencies, people in both countries would
benefit and trade should be encouraged. His theory stated that a nation’s wealth shouldn’t
be judged by how much gold and silver it had but rather by the living standards of its
people.

Comparative Cost theory,

The challenge to the absolute advantage theory was that some countries may be better at
producing both goods and, therefore, have an advantage in many areas. In contrast,
another country may not have any useful absolute advantages. To answer this challenge,
David Ricardo, an English economist, introduced the theory of comparative advantage in
1817. Ricardo reasoned that even if Country A had the absolute advantage in the
production of both products, specialization and trade could still occur between two
countries.
Comparative advantage occurs when a country cannot produce a product more efficiently
than the other country; however, it can produce that product better and more efficiently
than it does other goods. The difference between these two theories is subtle.
Comparative advantage focuses on the relative productivity differences, whereas absolute
advantage looks at the absolute productivity.

Let’s look at a simplified hypothetical example to illustrate the subtle difference between
these principles. Miranda is a Wall Street lawyer who charges $500 per hour for her legal
services. It turns out that Miranda can also type faster than the administrative assistants in
her office, who are paid $40 per hour. Even though Miranda clearly has the absolute
advantage in both skill sets, should she do both jobs? No. For every hour Miranda
decides to type instead of do legal work, she would be giving up $460 in income. Her
productivity and income will be highest if she specializes in the higher-paid legal services
and hires the most qualified administrative assistant, who can type fast, although a little
slower than Miranda. By having both Miranda and her assistant concentrate on their
respective tasks, their overall productivity as a team is higher. This is comparative
advantage. A person or a country will specialize in doing what they do relatively better.
In reality, the world economy is more complex and consists of more than two countries
and products. Barriers to trade may exist, and goods must be transported, stored, and
distributed. However, this simplistic example demonstrates the basis of the comparative
advantage theory.

Factor endowment theory,

The theories of Smith and Ricardo didn’t help countries determine which products would
give a country an advantage. Both theories assumed that free and open markets would
lead countries and producers to determine which goods they could produce more
efficiently. In the early 1900s, two Swedish economists, Eli Heckscher and Bertil Ohlin,
focused their attention on how a country could gain comparative advantage by producing
products that utilized factors that were in abundance in the country. Their theory is based
on a country’s production factors—land, labor, and capital, which provide the funds for
investment in plants and equipment. They determined that the cost of any factor or
resource was a function of supply and demand. Factors that were in great supply relative
to demand would be cheaper; factors in great demand relative to supply would be more
expensive. Their theory, also called the factor proportions theory, stated that countries
would produce and export goods that required resources or factors that were in great
supply and, therefore, cheaper production factors. In contrast, countries would import
goods that required resources that were in short supply, but higher demand.

For example, China and India are home to cheap, large pools of labor. Hence these
countries have become the optimal locations for labor-intensive industries like textiles
and garments.
International Product life Cycles Theory,

Raymond Vernon, a Harvard Business School professor, developed the product life cycle
theory in the 1960s. The theory, originating in the field of marketing, stated that a product
life cycle has three distinct stages: (1) new product, (2) maturing product, and (3)
standardized product. The theory assumed that production of the new product will occur
completely in the home country of its innovation. In the 1960s this was a useful theory to
explain the manufacturing success of the United States. US manufacturing was the
globally dominant producer in many industries after World War II.

It has also been used to describe how the personal computer (PC) went through its
product cycle. The PC was a new product in the 1970s and developed into a mature
product during the 1980s and 1990s. Today, the PC is in the standardized product stage,
and the majority of manufacturing and production process is done in low-cost countries
in Asia and Mexico.

The product life cycle theory has been less able to explain current trade patterns where
innovation and manufacturing occur around the world. For example, global companies
even conduct research and development in developing markets where highly skilled labor
and facilities are usually cheaper. Even though research and development is typically
associated with the first or new product stage and therefore completed in the home
country, these developing or emerging-market countries, such as India and China, offer
both highly skilled labor and new research facilities at a substantial cost advantage for
global firms.

International Investment Theories:

Theory of Capital Movements,

According to this theory international trade is the result of movement of capital from one
country to another for investment and return. Due to such movement of capital in the
form of FDI or FII, trade is the by product.

Market Imperfections theory;

Common situations that violate perfect competition are market structures like
monopolies, monopolistic competition, and oligopolies. With international trade, firms
are seen as price takers because they are only a small part of a foreign market. They can't
influence the price, have to deal with government interference related to trade, and
operate with imperfect information. This is why foreign automotive companies moved
some operations to the United States.

What is interesting about market imperfections theory is that it is an international trade

and investment theory. It tells us that in international markets, certain protections are
necessary to safeguard our interests. Free trade is a function of perfect competition, and
given that it doesn't exist, we need to look at ways to get more desirable outcomes. This
is where government interference enters.

Internationalization Theory;

In economics, internationalization is the process of increasing involvement of enterprises

in international markets, although there is no agreed definition of internationalization.
There are several internationalization theories which try to explain why there are
international activities

Location Specific Advantage Theory;

Location theory is concerned with the geographic location of economic activity; it has
become an integral part of economic geography, regional science, and spatial economics.
Location theory addresses the questions of what economic activities are located where
and why. Location theory rests — like microeconomic theory generally — on the
assumption that agents act in their own self-interest. Thus firms choose locations that
maximize their profits and individuals choose locations, that maximize their utility.

Eclectic Theory

An eclectic paradigm is a theory that provides a three-tiered framework for a company to

follow when determining if it is beneficial to pursue direct foreign investment (DFI). The
eclectic theory paradigm is based on the assumption that institutions will avoid
transactions in the open market when internal transactions carry lower costs.

Free Trade: Advantages and Disadvantages,

Free trade is a type of economic policy that allows member countries to import and
export goods among each other with lower or no tariff imposed. While supporters say
that it is a win-win situation for both consumers and traders with free access to the market
and information and without trade barriers, not all people (including economists) agree,
saying that this way of trading allows for foreign competition to cause certain economic
issues. To build a well-informed opinion whether free trade is more beneficial than not,
let us take a look at its key advantages and disadvantages.

List of Advantages of Free Trade

1. It provides consumers with more options and the benefit of lower prices.

Proponents argue that, with imported products from other countries with lesser or without
tariff, consumers can choose from a plethora of products, unlike when there is monopoly
in the market. Also, the high level of freedom in this trade will result to reduced prices.
2. It benefits trading countries through competitive advantage.

It is stated that countries that have enough resources to produce certain products will
enjoy competitive advantage to specialize in such goods and be their only suppliers to
other countries. In return, the purchasing countries can also benefit from the low prices of
these imported products. Therefore, it is a win-win situation for both trading nations.

3. It is a key to economic growth.

Countries that are engaging in free trade are seen to have richer economies. By
specializing in certain products with plenty of materials to make of, they maintain a high
level of productivity. Also, there exists productive competition, where products are traded
at lower prices. All these aspects are good for economic growth.

List of Disadvantages of Free Trade

1. It will have an unfavorable effect on local businesses and producers.

Opponents argue that free trade is not beneficial to local businesses and producers in
terms of profits. They explain that, with the reduced or zero tariffs imposed making
foreign suppliers easily lowering their prices, local companies have to compete with the
prices, which they should do even if it is difficult for them, or consumers will go for
imported goods over their locally produced products.

2. It would cause workers to live in desolate places for their jobs and be paid with low
wages.

Free trade is believed to force laborers in poorer countries to work long hours and live in
shanties without the basic facilities, just to be able to keep their work and send money to
their families.

3. It would rob the citizens of jobs that are supposed to be theirs.

Some groups say that this form of trading has taken away job opportunities for the
average American, as some manufacturers are encouraged to hire foreign workers for
cheaper labor and even relocate their facilities overseas.

The debate on free trade has remained to be a divisive issue between proponents and
opponents. But by weighing down its advantages and disadvantages, we will be able to
come up with a well-informed decision ourselves.
World Trade Environment
Introduction to World Trade

World trade has grown considerably over the years. The world merchandise exports grew from
US$59 billion in 1948 to US$13.57 trillion in 2007, and imports grew from US$62 billion to US$
13.94 trillion during the same period.

The exports of services grew more rapidly compared to merchandise exports from US$390.8
billion in 1980 to US$3.26 trillion in 2007 whereas during the same period, imports rose from
US$431.8 billion in 1980 to US$3.06 trillion in 2007.

A cross-country comparison of the share of world merchandise exports (Table 3.2) reveals that
the share of the US in the world merchandise exports significantly fell down from 21.7 per cent
in 1948 to 8.6 per cent in 2007 whereas the share of the UK declined from 11.4 per cent in 1948
to 3.2 per cent in 2007 (Fig. 3.2).
The share of Japan and China increased significantly from 0.4 per cent and 0.9 per cent in 1948
to 5.3 per cent and 9.0 per cent, respectively, in 2007 While the share of Asian countries such
as China and Japan grew remarkably in the world merchandise exports, India’s share in world
trade declined from 2.2 per cent in 1948 to 1 per cent by 1963 and further to 0.5 per cent in
1973. In 1980, the erosion was lowest at 0.42 per cent.

However, it subsequently increased sluggishly to a 1.1 per cent share of world trade in 2007.

World merchandise exports in dollar terms rose by 11 per cent to US$ 11.76 trillion during 2000-
06 whereas commercial services export during the same period rose by 10 per cent to US$2.71
trillion. Inflation contributed to about 40 per cent of the value change in 2006 of the merchandise
exports.

The commercial services with US$3.26 trillion accounted for 19.4 per cent whereas the
merchandise exports with US$13.57 trillion in 2007 accounted for 80.6 per cent of world trade,
as indicated in Fig. 3.3.
The review of world merchandise trade by leading exporters and importers reconfirms the
importance of price developments and the outstanding trade performance of China and India.
Since 2000, China has more than doubled its share in world merchandise exports.

Direction of World Trade:

The direction of trade is often referred to describe the statistical analysis of the set of a country’s
trading partners and their significance in trade. The set of countries where the goods are
exported to and their significance on a country’s exports is known as the ‘direction of exports’.

On the other hand, the set of countries from where the goods are imported and their
significance on a country’s imports is known as the ‘direction of imports’.

There has been a considerable change in the direction of world merchandise exports over the
years, as indicated in Fig. 3.4. The developed economies have traditionally dominated the world
exports with 66.39 per cent share in 1980, which increased to 72.34 per cent in 1990 but
subsequently declined gradually to 58.62 per cent by 2007 (Table 3.3).
Developing economies that accounted for 29.41 per cent share in world exports in 1980
declined to 24.25 per cent in 1990, grew to 31.85 per cent in 2000, and further increased to
37.52 per cent in 2007. The share of economies in transition in world exports fell from 4.20 per
cent in 1980 to 3.41 per cent in 1990 and 2.39 per cent in 2000. However, it subsequently
increased to 3.14 per cent in 2007.

The exports of developed economies increased by 86.56 per cent during 1980-90 whereas it
increased by 41.22 per cent for developing economies during this period. However, exports
from developing economies rose remarkably by 143.7 per cent during 1990-2000 and 152.38
per cent during 2000-07, compared to 68.66 per cent and 91.03 per cent, respectively, from
developed economies.

The exports from the economies in transition grew merely by 38.96 per cent during 1980-90, but
declined to 30.16 per cent during 1990-2000. However, the economies in transition exhibited a
further remarkable jump to 180.69 per cent during 2000-07, making it the region with the highest
export growth.

A region-wise comparison indicates that the share of North America in world merchandise
exports declined significantly from 28.3 per cent in 1948 to 14.2 per cent in 2006 whereas the
share of South and Central America fell from 12.3 per cent in 1948 to 3.6 per cent in 2006 and
the share of Africa dropped from 73 per cent in 1948 to 3.1 per cent in 2006 (Table 3.2).

On the other hand, the share of Europe in world merchandise exports increased from 31.5 per
cent in 1948 to 42.1 per cent in 2006, the share of the Middle East rose from 2 per cent to 5.5
per cent, and that of Asia grew from 13.6 per cent to 278 per cent during the same period.

Regions with the highest share of fuels and other mining products in their merchandise exports,
such as the Middle East (70%), Africa (65%), the CIS (60%), and South/Central America (37%)
recorded the highest increase in their exports in 2006.

Out of the total world merchandise exports of US$13.57 trillions in 2007, Europe with US$5.76
trillion exports accounted for 42.5 per cent in 2007 followed by Asia with US$3.79 trillion
(28.0%), North America with US$1.85 trillion (13.7%),
Middle East with US$721 billion (5.3%), CIS with US$508 billion (3.7%), South and Central
America with US$496 billion (3.7%), and Africa with US$422 billion (3.1%), as depicted in Fig.
3.5. In 2007, Europe with US$6.05 trillion accounted for 43.4 per cent of world merchandise
imports worth US$13.94 trillion (Fig. 3.6), followed by Asia with US$3.52 trillion (25.3%), North
America with US$2.70 trillion (19.4%), Middle East with US$462 billion (3.3%), South and
Central America with US$455 billion (3.3%), CIS with US$377 billion (2.7%), and Africa with
US$355 billion (2.6%).

Germany ranked as the leading exporter in 2007 with US$1.32 trillion accounting for 9.5 per
cent share of world exports, followed by China (8.8%), the US (8.4%), Japan (5.1%), and
France (4.0%), as given in Table 3.5. The US remained the single largest importer with US$2.01
trillion, accounting for 14.2 per cent share of world imports, followed by Germany (75%), China
(6.7%), Japan (4.4%), UK (4.3%), and France (4.3%).

India ranked at 26th position with US$ 145 billion, accounting for 1.0 per cent share in exports of
world merchandise trade whereas it ranked at 18th with US$217 billion with 1.5 per cent share
in merchandise imports in 2007.
The analysis provided in Exhibit 3.2 indicates that China and India are likely to dominate world
trade in the future. Moderate and sluggish export value growth of less than 10 per cent was
reported by Japan (9%), France (6%), Spain (7%), and Ireland (3%) during the period 2006.

The merchandise imports (Table 3.5) of these countries also expanded far less rapidly than the
world average. It is noteworthy that the ten leading exporters comprise the same countries as
the group of the top ten leading importers, although the annual variation of trade differed
markedly between the leading traders.
Composition of World Merchandise Trade:

The statistical analysis of a country’s product groups in its international trade is often referred to
as the ‘composition of trade’. This can be carried out for the trade with all the countries in the
world collectively or individually, with a group of countries, or a particular country.

Such analysis carried out for product groups exported is known as the ‘composition of exports’
whereas the analysis carried out for product groups imported is known as the ‘composition of
imports’.

There has been a significant shift in the composition of world merchandise exports over the last
four decades, as shown in Fig. 3.7. Food exports that accounted for 18.2 per cent of the world
merchandise exports in 1965 declined to 6.7 per cent in 2000 and 6.2 per cent in 2006 (Table
3.6).
Agricultural raw material that constituted 78 per cent of world merchandise export in 1965
declined to 1.9 per cent by 2000 and 1.5 per cent in 2006.

The share of ores, metals, and precious stones in world merchandise exports declined from 12
per cent in 1965 to 5.5 per cent in 2006, whereas the export of fuels grew from 9.6 per cent in
1965 to 24 per cent in 1980, but subsequently declined to 14.5 per cent by 2006. Manufactured
goods have shown a gradual rise from 49.8 per cent in 1965 to 76.5 per cent in 2006.

During recent years, weak and stagnating prices of food, agricultural raw materials, and
manufactured goods contrasted with a further steep rise in prices for metals and fuels. The
share of fuels increased to 13.3 per cent in 2005. On the other hand, the share of food and
agricultural raw materials in the world merchandise exports decreased to a historic record low of
8 per cent in 2005.
Although recent oil price developments played a major role in the further relative decline of
agricultural products in world merchandise exports, they only accentuated an existing long-term
downward trend.

The share of agricultural products in the world merchandise exports has decreased steadily
over the last six years from more than 40 per cent in the early 1950s to 10 per cent in the late
1990s, as both volume and price trends have been less favourable than for other merchandise
products.

Despite the decline in the share of agricultural products in world exports, the export value of
agricultural products in world trade has increased thirty-folds between 1950 and 2005.

During the 1990s, the export value of electronic goods rose an average by 12 per cent or two
times faster than all other manufactured goods. Among the manufactured goods, it is estimated
that the largest value increases during recent years were for iron and steel products, as well for
chemicals.

Although, there was a recovery in the global demand for computers and other electronic
products, the growth rate of their trade value was less than that of manufactured goods.

Fuels with exports worth US$ 1.8 trillion, as given in Table 3.7, accounted for 17.2 per cent of
world merchandise exports in 2006, followed by office and telecommunication equipment’s
(14.1%), other machinery (14.0%), automotive products (9.8%), agricul-tural products (9.2%),
other chemicals (9.1%), other semi manufactures (7.7%), iron and steel (3.6%), clothing (3.0%),
pharmaceuticals (3.0%), scientific and control instru-ments (2.3%), textiles (2.1%), and ores and
minerals (1.9%), as shown in Fig. 3.8.
The growth in share of manufactures in total exports has a significant impact on the overall
export. The gradual shift towards manufacturing has led to rapid export growth where the share
of manufactured exports was already large.

Developing countries derived 70 per cent of the merchandise export revenue from the sales of
primary commodities—agriculture and energy—two decades ago, whereas presently 80 per
cent of the revenue comes from the export of manufactured goods.

Developing countries now rely less on the shipments of primary commodities than on
manufactured goods. Even exports from sub-Saharan Africa are no longer resource based. The
share of manufactures in African exports has risen from 25 per cent during the late 1970s to 67
per cent in 2006.

World Commercial Services Trade:

The world commercial services exports rose by 21 per cent to US$3.26 trillion in 2007. Since
the commercial services data are derived from BoP statistics, it does not include the sales of
majority-owned foreign affiliates abroad. The expansion rate of global services trade has
remained largely consistent during the last six years.

‘Other commercial services’, which includes software, education, health financial services, etc.,
has been the fastest growing category at 12 per cent growth in the world exports of commercial
services trade.

Asia’s commercial services exports continued to expand faster than the global average for the
third consecutive year in 2006 and also faster than the region’s services imports, thereby
reducing the region’s deficit and service trade. India continues to excel in its services trade
expansion.
Direction of World Commercial Services Trade:

In 2007, Europe with US$1.66 trillion accounted for 51 per cent of total world commercial
services exports (Fig. 3.9) worth US$3.26 trillion, followed by Asia with US$745 billion (22.9%),
North America with US$533 billion (16.4%), South and Central America with US$91 billion
(2.8%), Africa with US$84 billion (2.6%), Middle East with US$79 billion (2.4%), and CIS with
US$64 billion (2.0%).

Europe also ranked as the highest importer of world commercial services with US$ 1.43 trillion
(46.8%), followed by Asia with US$778 billion (25.4%), North America with US$440 billion
(14.4%), Middle East with US$125 billion (4.1%), Africa and South Central America with US$97
billion (3.2%), and CIS with US$90 billion (2.9%) of the total import of world commercial services
(Fig. 3.10) worth US$3.06 trillion in 2007.

A country-wise analysis of world commercial services as delineated in Table 3.8 reveals that the
US was the largest exporter of commercial services in 2007 with US$454 billion, accounting for
13.9 per cent of the world commercial services trade, followed by the UK (8.1%), Germany
(6.1%), Japan (4.2%), and France (4.0%).
The US was also the largest importer of services with US$336 billion, accounting for 11.0 per
cent, followed by Germany (8.0%), UK (6.3 %), Japan (5.1%), and China (4.2%). India ranked at
11th position with US$86 billion, accounting for 2.7 per cent share in export of world commercial
services whereas it ranked 13th with US$78 billion with 2.6 per cent share in services imports in
2007.

Composition of World Commercial Services Trade:

The category-wise break-up of commercial services of exports in Fig. 3.11 indicates that travel
accounted for US$862 billion (26.5%), transport for US$742 billion (22.8%), and other
commercial services for US$1653 billion (50.8%).
It is interesting to note that other commercial services are not only the largest category but also
the fastest growing category. During 2000-06, the world trade of commercial services grew at
the rate of 10 per cent, wherein transport increased by 10 per cent, travel by 7 per cent, and
other commercial services rose by 12 per cent.

Government intervention in International Trade

Internationally, free trade implies the unrestricted flow of products and services across national borders.
Free trade offers nations numerous advantages. Governments erect trade barriers and intervene in
other ways that restrict or alter free trade. Protectionism refers to trade and investment barriers applied
with the aim of defending domestic markets and industries. Tariffs and nontariff trade barriers are the
main instruments of protectionism. A tariff is a tax imposed by government on imported goods. Tariffs
have fallen over time, but many high in many countries. Nontariff trade barriers are government policies
or measures that restrict trade without imposing a direct tariff or duty. Subsidies are financial or other
resources that a government provides to a firm or group of firms. Governments undertake intervention
to achieve several goals, including: to generate revenue, to achieve policy objectives, and to protect or
support the nation's citizens or private firms.

Argument for govt. intervention in international trade

Govts world over intervene in international trade through mostly policy measures in order to
protect

1. Jobs
2. National Security
3. Retaliation
4. Consumers
5. Foreign Policy
6. Human Rights
7. Environment
Jobs

This is the most common political reason for trade restrictions. Protecting the interests of
certain groups within a nation (normally producers), often at the expense of other groups
(normally consumers)

National Security

Industries are often protected because they are deemed important for national security. For
example - aerospace or semiconductors
Retaliation

When governments take, or threaten to take, specific actions, other countries may increase
trade barriers e.g., U.S. & E.U. over beef with growth hormones or Indo – Pak relationship
Consumers

Protect consumers from “unsafe” products e.g., FDA limit papayas from Mexico due to possible
Salmonella

Foreign Policy

Preferential trade terms may be granted to countries that a government wants to build strong
relations with. Also used to punish rogue states e.g., North Korea, Cuba, Pakistan

Human Rights

Protect and promote human rights through trade policy actions. e.g., India Granted Pakistan
MFN status in spite of bad behavior (although removed recently due to extreme bad behavior)

Environment

Protect environment because international trade is associated with a decline in environmental

quality. Concern over global warming Enforcement of environmental regulations (ISO 14,000)

Instruments of Commercial Policy

1. Tariffs

- Taxes levied on imports that effectively raise the cost of imported products relative to domestic
products. These of two types

1. Specific tariffs - levied as a fixed charge for each unit of a good imported ($/ kilo)
2. Ad valorem tariffs - levied as a proportion of the value of the imported good (%)

2. Subsidies - government payments to domestic producers. Subsidies help domestic producers compete
against low-cost foreign imports gain export markets. Consumers typically absorb the costs of subsidies
3. Import Quotas

- Restrict the quantity of some good that may be imported into a country

e.g. Tariff rate quotas - a hybrid of a quota and a tariff where a lower tariff is applied to imports within
the quota than to those over the quota

4. Voluntary Export Restraints - quotas on trade imposed by the exporting country, typically at the
request of the importing country’s government

e.g.,

Japanese auto exports to U.S. U.S. put pressure on Japan to reduce export volume of autos to the U.S.
1981

5. Local Content Requirements - demand that some specific fraction of a good be produced domestically
(NAFTA)

 benefit domestic producers

 consumers face higher prices

6. Administrative Policies (informal barriers) - bureaucratic rules designed to make it difficult for imports
to enter a country polices hurt consumers by limiting choice

E.g., Customs procedures hamper imports

7. Antidumping Policies – aka countervailing duties - punish foreign firms that engage in dumping and
protect domestic producers from “unfair” foreign competition

What is dumping? - selling goods in a foreign market below their costs of production, or selling goods in
a foreign market below their “fair” market value

Impact of tariff and non tariff barriers

The benefits of tariffs are uneven. Because a tariff is a tax, the government will see increased revenue as
imports enter the domestic market. Domestic industries also benefit from a reduction in competition,
since import prices are artificially inflated. Unfortunately for consumers - both individual consumers and
businesses - higher import prices mean higher prices for goods. If the price of steel is inflated due to
tariffs, individual consumers pay more for products using steel, and businesses pay more for steel that
they use to make goods. In short, tariffs and trade barriers tend to be pro-producer and anti-consumer.

The effect of tariffs and trade barriers on businesses, consumers and the government shifts over time. In
the short run, higher prices for goods can reduce consumption by individual consumers and by
businesses. During this period, some businesses will profit, and the government will see an increase in
revenue from duties. In the long term, these businesses may see a decline in efficiency due to a lack of
competition, and may also see a reduction in profits due to the emergence of substitutes for their
products. For the government, the long-term effect of subsidies is an increase in the demand for public
services, since increased prices, especially in foodstuffs, leave less disposable income. (For related
reading, check out In Praise Of Trade Deficits.)

How Do Tariffs Affect Prices?

Tariffs increase the prices of imported goods. Because of this, domestic producers are not forced to
reduce their prices from increased competition, and domestic consumers are left paying higher prices as
a result. Tariffs also reduce efficiencies by allowing companies that would not exist in a more
competitive market to remain open.

Figure 1 illustrates the effects of world trade without the presence of a tariff. In the graph, DS means
domestic supply and DD means domestic demand. The price of goods at home is found at price P, while
the world price is found at P*. At a lower price, domestic consumers will consume Qw worth of goods,
but because the home country can only produce up to Qd, it must import Qw-Qd worth of goods.

Figure 1. Price without the influence of a tariff

When a tariff or other price-increasing policy is put in place, the effect is to increase prices and limit the
volume of imports. In Figure 2, price increases from the non-tariff P* to P'. Because the price has
increased, more domestic companies are willing to produce the good, so Qd moves right. This also shifts
Qw left. The overall effect is a reduction in imports, increased domestic production, and higher
consumer prices. (To learn more about the movement of equilibrium due to changes in supply and
demand, read Understanding Supply-Side Economics.)
Figure 2. Price under the effects of a tariff

Tariffs and Modern Trade

The role tariffs play in international trade has declined in modern times. One of the primary reasons for
the decline is the introduction of international organizations designed to improve free trade, such as
the World Trade Organization (WTO). Such organizations make it more difficult for a country to levy
tariffs and taxes on imported goods, and can reduce the likelihood of retaliatory taxes. Because of this,
countries have shifted to non-tariff barriers, such as quotas and export restraints. Organizations like the
WTO attempt to reduce production and consumption distortions created by tariffs. These distortions are
the result of domestic producers making goods due to inflated prices, and consumers purchasing fewer
goods because prices have increased. (To learn about the WTO's efforts, read What Is The World Trade
Organization?)

Since the 1930s, many developed countries have reduced tariffs and trade barriers, which has improved
global integration and brought about globalization. Multilateral agreements between governments
increase the likelihood of tariff reduction, while enforcement of binding agreements reduces
uncertainty.

The Bottom Line

Free trade benefits consumers through increased choice and reduced prices, but because the global
economy brings with it uncertainty, many governments impose tariffs and other trade barriers to
protect the industry. There is a delicate balance between the pursuit of efficiencies and the
government's need to ensure low unemployment.

Introduction to India's Foreign Trade ↓

Foreign Trade is one of the significant macro fundamental variable of an economy. India till
recently was predominantly a primary goods exporting and mainly an industrial goods importing
country.

In 1950s, India's share in the world trade was 1.78% which was decline to 0.59% in 1990 and
has since increased to around 2.2% now. India's share in world exports was 0.8% in 2006.

Composition and Direction of Trade - Export, Imports of India

Composition of trade means a study of the goods and services of imports and exports of a
country. In other words, it tells about the commodities of imports and the commodities of exports
of a country. Therefore it indicates the structure and level of economic development of a
country. Developing countries export raw materials, agricultural products and intermediate
goods; developed countries export finished goods, machines, equipments and technique.

Direction of trade means a study of the countries to whom the exports are made and from whom
the imports are made.

Composition of India's Imports ↓

In 1947-48 the main items of India's imports were machineries, oil, grains, cotton, cutlery,
hardware implements, chemicals, etc. They constituted 70% of India's imports. After that due to
the emphasis on industrialisation during the second 5-Year plan necessitated the imports of
capital goods.

Now imports of India's are broadly classified into following four categories.

Table below shows composition of India's import from 1990-91 to 2005-06.

Imports of India may be divided into three parts namely capital goods, raw materials and
consumer goods.

Imports of capital goods

Capital goods include metals, machines and equipments, appliances and transport equipments,
and means of communications. These goods are essential for industrial development of the
country. Imports of these goods amounted to Rs.356 crore in 1960-61 which increased to
Rs.26, 532 crore in 1997-98.

Imports of raw materials and intermediate goods

It includes the imports of cotton, jute, fertilizer, chemicals, crude oil etc. A number of raw
materials and intermediate goods have to be imported during the process of economic
development. If amounted to Rs.527 crore in 1960-61 which increased to Rs.13, 966 crore in
1985-86. Petroleum products include crude oil, petrol and lubricating oil. Imports of these
products have ever been increasing. In 1960-61, imports of these products amounted to Rs.69
crore which increased to Rs.30, 538 crore in 1997-98. Import of petroleum products constitutes
about 23 percent of our total imports. Fertilizers are an important input for agriculture. Chemical
products are an important input for industrial development. The import of these products is
continuously increasing in India. In 1960-61 import of these items amounted to Rs.88 crore only
which increased to Rs.3755 crore in 1997-98.

Imports of consumer goods

It includes the import of food grains, electrical goods, medicines, paper etc., India faced an
acute shortage of food grains till the end of Third Five Year Plan. As a result, India had to import
food grains in large quantities. Import of food grains in 1960-61 was 3748 thousand tonnes
(Rs.181 crore). In 1997-98 it was 1399 thousand tones. Now India has achieved self-reliance in
food production.
Direction or sources of imports of India

Sources of imports of India have undergone several important changes during the planning
period. Some important facts are as follows:

At the beginning of economic planning, we were importing from selected countries only. Now
the picture has changed. We import different goods and services from different countries of the
world. At present we get our imports from almost all the countries of the world. For the purchase
of machines and equipments, we depend mainly on OECD (Organization for Economic
Cooperation and Development) countries and East European countries. For the supply of food
grains and petroleum products, we depend on OPEC (Oil Producing and Exporting Countries)
countries. The OECD countries supply largest part of our imports. In 1997-98 out of the total
imports of Rs.1,51,553 crore, the imports of Rs.75,593 crore were made (49.9%) from these
countries. Other important suppliers of our imports are USA, Belgium, Germany, Japan and
Britain.

Composition of exports of India

Britishers strongly believed that India was a country well suited to supply raw materials and
other primary goods and a good market place for British manufacturers. So at the time of our
independence our exports were predominantly of primary goods and imports were of
manufacturers. At the time of independence agricultural commodities and light manufactured
consumer goods dominated India's export basket. During the post independence period India's
composition of exports changed.

Now exports of India's are broadly classified into following four categories.

Table below shows composition of India's export from 1990-91 to 2005-06.

Exports of India may be divided into two parts I) Exports of traditional items and ii) Exports of
non-traditional items.

Exports of traditional items

It includes the exports of tea, coffee, jute, jute products, iron ore, species, animal skin, cotton,
fish, fish products, mineral products etc. At the beginning of the planning era, their items
contributed about 80 percent of out total exports. Gradually, the contribution of these items is
declining and that of non-traditional items is increasing. At present the contribution of traditional
items is about 18.8% in our total exports.

Non-traditional items

It includes the export of sugar, engineering goods, chemicals, iron and steel electrical goods,
leather products, gems and jewellery. There is a significant change in the pattern of exports of
India during recent years. India has started to export a number of non-traditional items to a
number of countries of the world. Contribution of these items is gradually increasing in total
exports of India and shows a declining trend during some years also. Some facts to illustrate the
changes are given below:

Agriculture and allied products which constituted 20.4 percent of total exports in 1996-97,
decreased to 18.8 percent in 1999-2000. ii) Ores and minerals which constituted 3.5 percent of
total exports in 1996-97, decreased to 3 percent in 1999-2000. iii) Manufactured good which
contributed 73.4 percent of total exports in 1996-97, increased to 75.7 percent in 1999-2000. iv)
Crude and petroleum products constituted 1.4 percent of total exports in 1996-97 but decreased
to 1.0 percent in 1999-2000. v) With regard to other items of exports which constituted 1.2
percent in 1996-97 increased to 1.3 percent in 1999-2000.

Direction of exports of India

During the planning era, several important changes have taken place in the destination of
exports of India. At present, we deal with about 180 countries including many developed
countries. Our major exports are directed towards the following countries
 OECD countries (Belgium, France Germany, U.K. North America, Canada, USA,
Australia and Japan). Our exports which constituted percent of the total exports in 1990-
91 increased to 55.7 percent in 1999-2000.
 OPEC countries (Iran, Iraq, Kuwait, Saudi Arabia etc.). Our exports which constituted 5.6
percent of the total exports in 1990-91 increased to 10.0 percent in 1999-2000.
 Eastern Europe (GDR, Romania, Russia etc.). Our exports which constituted 17.9
percent in 1990-91 decreased to 3.1 percent in 1999-2000.
 Other LDC's (Africa, Asia, Latin America). Our exports constitute 16.8 per cent in 1990-
91, increased to 28.2 percent in 1999-2000.
 To sum up, during the last five decades, significant changes have been observed in the
volume, composition and direction of India's trade. Most of these changes have been in
consonance with the development needs of the economy.