UNIT 1 INTRODUCTION TO

ATIONAL BUSINESS
ENVIRONMENT
/ Structure
1.0 0b.jectives
I. 1 Introduction
1.2 Concept and Relevance of International Business Environment
1.2.1 Micro and Macro Environments
1.2.2 Domestic, Foreign and Global Environment
1.2.3 Rclevnnce of International Business Environment
1.3 Analysis of the Components of Foreign Environment
1.4 Geographic Environment
1.5 Economic and Financial Environment
1.5.1 Econot~licEnvironment
1.5.2 Financial Environment
1 .G Socio-Cultural Environment
1.7 Political Environment
1.8 Legal Environment
1.9 Ecological Environment
1 .I 0 Let Us Sum Up
I. 1 1 Key Words
1.12 Answers to Check Your Progress
1.13 Terminal Questions

1.0 OBJECTIVES
After going through this unit, you should be able to:

I 8 explain the meaning, nature and relevance of international business environment

i 8 describe the domestic, foreign and global dimensions of international business environ-
ment
I 8 analyse geograpl~ic,economic, financial, socio-cultural, political, legal and ecological
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components of a foreign country's environment

j discuss implications of each components of international business environment.

1.1 INTRODUCTION
Business is defined as a set of activities relating to industry and commerce. When these
activities are performed on an international level, these can be termed as international
business. Basic functions, processes and techniques of international business are essentially
the same as those involved in domestic business. What is different is the environment
within which these functions are performed and processes are carried out, While doing
business within one's own country, one is familiar with most of the environ~nentalfactors
and is readily able to cope with them. But the task of managing international business is
not that easy. Because of operating in environments which are unfamiliar and different
from the domestic environment, one needs to be extra careful and vigilant to these environ-
mental differences. These variations may need adaptation for business success. h this unit,
you will learn the meaning, nature and relevance of the international business environment. .
You will further learn in detail the geographical, economic, financial, socio-cultural, legal and
ecological aspects of global business environment.
 ~'o~tccpls~d-l)l~ncn~Iuns Introduction to I n t c r n ~ t i o n ~ l 1
1.2 CONCEPT AND RELEVANCE OF I in which a firm operates. Differences exist not only between domestic and foreign environ- Business Envlronmcnt 1
INTERNATIONAL BUSINESS ENVIRONMENT
Simply speaking, environmentrefers to one's milieu or surrounding. In the context of a
i ments. but also among the environments prevailing in different foreign markets. Because. -
of environmental differences, business strategies that are successful in one nation might fail
luiserably in other countries. Foreign market operations, therefore, require an increased
sensitivity to the environmental differences and adaptation of business strategies to suit the
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business firm,environment can be defined as various extemal actors and forces that surround
differing market situations.
the firmand influence its decisions and operations. The two major characteristics of the
environment as pointed out by this definition are: one these actors and forces are extemal to . Figure 1.1 International Business Environment
the firm, and secondly these are essentially uncontrollable. The firm can do little to change
them. It has to rather learn to live with them.
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1.2.1 Micro and Macro Environments

In order to gain a better understanding, let us have a look at two important classifications of
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environment One classification is the micro and macro environments.

Micro environment can be defined as the actors in the firm's immediate environment
which directly influence the firm's decisions and operations. These include: suppliers:
various market intermediaries and service organisations such as middlemen, transporters,
warehouses, advertising and marketing research agencies, business consulting firms and
financial institutions; competitors, customers and general public. While the customers
constitute firm's market, suppliers and market intermediaries help providing the firm with
inputs and assist in production and marketing processes. Competitors and general public
,also influence the way a finn conducts its business.

Macro enviro"mcnt, on the other hand, consists of broader forces which affect the firm as
well as other actors in the firm's micro environment. These include factors such as geo-
graphic, economic, financial, socio-cultural, political, legal, technological and ecological
forces. Firms need to continuously monitor changes in these environmental forces and
devise strategies to cope with them.
3.J

1.2.2 Domestic, Foreign and Global Environment

Another way of understanding various factors constituting intemational business environ-
ment is to divide the various factors into three broad groups: domestic, foreign and global
environments. This classification is based on the location at which environmental actors and
forces exi* and operate. Look at Figure 1.I where a schematic presentation ofthese three
levels of environment alongwith their components has been shown.

In the figure, innermost circle represents firm's business strategy and decisions with regard to
production, finance, marketing, human resources and research activities. Since these strate-
gies and decisions are made by the finn, they are called controllables. Firm can change them
but'within the constraints of various environmental factors.
The next circle represents domestic environment and it consists of factors such as competi-
tive structure, economic climate, and political and legal forces which are essentially uncon-
trollable by a firm. Besides profound effect on the firm's domestic business, these factors
exert influence on the firm's foreign market operations. Lack of domestic demand or
intense competition in the domestic market, for instance, have prompted many Indian
firms to plunge into international business. Export promotion measures and incentives in
country have been other motivating factors for the firms to internationalise their business
operations. Since these factors operate at the national level,.firms are generally familiar
with them and are able to readily react to them.
The third circle represents foreign environment consisting of factors like geographic and
economic conditions, socio-culturaj traits, political and legal forces, and technological and
ecological facets prevalent in a foreign country. Because of being operative in foreign
l market, firms are gen'erally not cognisant of these fact~rsand their influence on business
activities. The firm can neglect them only at the cost of losing business in the foreign
h markets. The problem gets more complicated with increase in number of foreign markets
The upper most circle, viz., circle four, represents the global environment. Global envi-
ronment transcends national boluidaries and is not confined in its impact to just one
country. Global environment exerts influence over domestic as well as foreign countries
and co~nprisesof forces like world economic conditions, international financial system,
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international agreements and treaties, and regional economic groupings. World-wide
econo~nicrecession; international financial liquidity or stability; working of the interna-
tional organisations such as World Trade Organisation (WTO), International Monetary
Fund (IMF), World Bank and the United Nations Conference on Trade and Development
(UNCTAD); Agreement on Textiles and Clothing (ATC); Generalised System of Prefer-
ences (GSP); International Commodity Agreements; and initiatives taken at regional levels
such as European Union (EU), North American Free Trade Association (NAFTA) and
Association of South East Asian Nations (ASEAN) are some of the examples of global
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environmental forces having world-wide or re'gional influences on business operations.
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1.2.3 Relevance of International Business Environment
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As stated earlier, environment plays a vital role in the conduct of business operations.
Especially in the context of international business, environment assumes critical importance .
as no two countries have similar environments and demand different business strategies to
cope with differing business conditions. As the environment affects firms' strategic as well
as tactical decisions, it becomes imperative for the firm to have .in-depth knowledge of the
domestic, foreign and global environments.

Conccpb and Dinlcnsiunr When a firm decides to enter into intetnational business, it faces two major decision prob-
lems: one, in which market(s) to select, and second how to enter into those markets. Both
these decisions are strategic in nature and are greatly influenced by the environmental
forces. Firms select those countries as their target markets which have sufficient market
potential. Market potential in turn depends upon geographic, economic and cultural
envimnme~tsprevailing in the foreign counries. Demand for fans, for instance, will be
more in countries which are geographically located in hot zones and where per capita
income is high enough for the people to afford purchase of fans. Besides climate and
sufficient income, electricity should be available to make the fans workable.
Once the firm identifies countries with market potentials, it needs to decide as to what
mode it should use for entering into those markets. A wide range of options such as
exporting, licensinglfranchising, joint ventun or setting up wholly owned subsidiaries
abroad are available to firms. Firm's actual choice of market entry mode is influenced by
a variety of environmental factors. Exporting is desirable when it is economical to produce
in the home country and there are no legal restrictions on import of given product in the
foreign markets. In the case of import bans or excessive costs of transportation, a firm may
choose to set up its manufacturing and marketing subsidiaries abroad. But this is feasible
only when foreign governments are not averse to foreign direct investment, and necessary
raw materials and labour are available locally at competitive prices in the foreign countries.
In countries where fvst condition is not fulfilled, the firm can go in for either licensing or
joint venture as these entry modes are politically less objectionable.
Environmental forces play an equally impoant role in shaping a firm's functional and
tactical decisions. What should be the scale of production? Should the firm employ labour
or capital intensive techniques? How to finance firm's foreign operations? How much to
repatriate? What marketing mix should the firm use? Should it hire local persons or
employ foreign nationals? What should be their compensation package? Answers to these
and other questions require in-depth analysis of the prevailing environments in foreign
countries. Since the environments differ, firm cannot be much successful by falling back
upon its domestic decisions and practices. Firm needs to screen the foreign country envi-
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ronments and accordingly decide about the best course of action in each country.
It may be pointed out here that environmental analysis is important not only for the firms
entering into the foreign markets for the first time, but it is also important for the firms
already in international business. Since environmental conditions change over time, firms
need to continuously monitor changes in the environment and mike suitable changes in
their decisions.
Check Your Progress A
1. What is micro environment?
2. Distinguish between domestic and foreign environments,
3. What do you mean by global environment? Introduction to International
Business ~nvironrnent
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4 4. Write three examples of global environmental forces having world-wide or regional
intluences on business operations.
5. State whether following statements are True or False.
i) Basic functions, processes and techniques of international business are
essentially the same as those involved in domestic business.
ii) Market intermediaries fall under macro environment.
iii) Legal forces are controllable by a firm.
iv) Business strategies which are successful in one country will also be successful
in another country.
V) Global environment exerts influence over domestic as well as foreign
countries,
1.3 ANALYSES OF THE COMPONENTS OF FOREIGN
ENVIRONMENT
All the three types of environments, viz., domestic, foreign 'and global environments, have
their effects on international business operations. Because of the vastness of subject, it is
not possible to discuss all the three types of environments and their impact on business in
one unit. The present unit, therefore, confines itself to a discussion of various components
of foreign environment. The other two types of environments and their business influences
are examined in detail in other units.
Foreign environment was described, in the preceding section as consisting af geographical,
economic, financial, socio-cultural, political, legal and ecological forces. A firm needs to
examine these componentszofthe environment for each one of the foreign countries in
which it operates. A brief description of these components and their influence on the firm's
international business operations is provided in the folloGing sub-sections.
Though'we shall be discussing each of the components separately, in reality there exists a
lot of overlapping as well as interactions among various components. Population, for
instance, is discussed in literature as,an element of both the physical and economic envi-
ronments. There is a lot of overlapping among the socio-cultural, legal and political forces.
Geographic characteristics of a counw have profound impact on the country's economic
and socio-cultural environments. '
Moreover, it should be kept in mjnd that ali the components-and elements of the environment
might not be relevant t o a decision maker. Much depends on the nature of the firm and its
decisions. For a small firm interested in exporting, analysis of the commercial policy and the
economic environment would be sufficient. But for a multinational corporation interested in
setting up a ~nanufacturingplant in a foreign country, geographic as well as socio-cultural,
 ( ' r ~ ~ ~ r r p l s :Di~ncnsiotls
~ad
legal and political environments wolild be as irnporlant as 111~.cconolnic c!ivr~.c~r~~nent.
Let L I +
Ctmc now learn these environrne~italcornpnncnts in detail.
1.4 GEOGRAPHIC ENVIRONMENrlf
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Geography is nn important con~pone~lt of the foreign enviro~lmentancl refers to a country's
climate, topography, natural resources and people. Everyone engaged in international
business must have some knowledge of geographic features of the Foreign country as these
influence the nature and characteristics of a society. It also affect demand pattern of the
people living in the cvuniry. Geography is a major contributo~yfactor to the development
of busincss systems, -trade ce~itresand ro~ites.
Diffcrelll cli~n:tliccol.~ditions(viz., ~ . i ~ i l~i .~ ~ l j w f wind,
a i l , tcn1pel.nture, hl.lmitlity, etc.,) give
rise to de~.nnndfor different types IOS 111.oducts.It is 1:ugely due to climatic dil'fc:rences that
people diff2r in their housing, clotlli~lg,fczoc!, 111edical and recreational needs. Many a tinle
nceds are same, and Ihc sa~rleproduds iirc den~anilcd. But because or the cli~nnticand
topogr:~phicdif'fel,cnces, prodricts need ucli~ptationor modifications to suit local conditions.
Rolls Royce cars fro111England, for instar~ce,~~equired extensive body work and renovations
i i i Canada because tlle salted sand, spread over streets to keep them passable throughout
four or five months of virtually continuous snow in Canada, caused rusting and corrosion
in the fenders and door panels and oil systen~also developed leaks.
Geographic conditions also affect a firm's plant location decision. A firm prefers to set up
its !nanufacturing plant in a country which has favourable climatic conditions, possesses
suitable topography (i.e., surface features such as hills, plains, river and sea) and where raw
materials, energy and labour are cheaply and abundantly available. Foreign country's
nearness to other markets and its strategic location on rnajor trade routes are other equally
irnporta~~tconsidel-ations.
Firms' distribution and logistic strategies are directly influenced by geographic conditions
in the foreign markets, Re-ordcr points and safely level stocks are kept generally higher for
those countries or places which are not easily accessible and can be cut off suddenly and
heavily d ~ r eto bad weatl.~er.
Location of a country on the world map is an cill~allyinlportant consideration. It affects its
trade prospects with other countries. Landlockcd countries such as Bolivia, Zambia and
Zimbabwe ,are not only costly to reach but are also difficult to penetrate as trading with
these countries depend upon their relations with neighbouring countries through which
goods have to cross.
Consumer demand for man), a low priced and essential product is directly related to the
number of people living in a country. It is primarily due to large populations thot :he
countries like China and India have become the targets of the multinational corporations
which are vying with one another to gain a foothold in these markets, To al-rivc: at a correct
estimate of the market size, however, one needs to take into ~ c c o u n other
t factors alsq such
as population growth, population density and population distribution by age, income,
location and occupation, ~ a k e ntogether, these variables provide better estimates o f the
present and future market potentials and also help in providing information relevant for
communication, distribution, product quality and pricing decisions.
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1.5 ECONOMIC AND FINANCIAL ENVIRONMENT
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Alnong all the uncontroliables, economic environment is pethaps the most important
factor. An analysis of econodic environment enables a firm to know how big is themarket
and what its nature is. Answers to these questions in turn determine whether a firm should
enter a given foreign market, and if yes, what strategies it should use to successfully run its
business operations, Closely related to the economic environment is the financial environ-
ment which affects a firm's capital stnlctr~re,investmentdecisions and accounting ~ractices.
Various dimensions one needs to consider while attempting an econoniic and financial introduction to lnternatiot~al
Business Environrncnl
analysis include : foreign country's level of econonlic development, income, expenditure
pattern, infrastructure including financial institutions and system, inflation, foreign invest-
ment in the country, commercial policy, balance of payments account, accounting systems
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and practices, and integtation of the foreign country's foreign exchange, money and capital
markets with the resl of the world. Let us learn these economic and financial environment in
detail.
1.5.1 Eco~lomicEnvironment
Economic environment is the most important indicator of the global market analysis. Let us
discuss the major ecor~omicindicator influe~~cing
the foreign market decisions.
Economic Developn~elrt:Economic development is directly related to the development of
mnrketing in a country. Countries characterised by high levels of economic development not
only liave high demand for a variety of products, b ~also
~ thave better infrastructure and more
b developed marketing systems. Competition is also high in these countries. In the less devel-
oped countries, on the other hand, not only demand is low, but infrastructure is also poor. It,
therefore, bccomes quite difficult and more expensive to do business in such nations.
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1 Income: Income is an important indicator of the country's level of development and also its
market size. Gross national product (GNP) and per capita income are among the major
measures of income. While sales of most of the industrial goods and capital equipment
generally col-relate with GNP, demand for consumer products depends on per capita income.
Besides income. one should acquire information about the sectoral distribution of the GNP
as it is an important determinant of kinds of goods in demand in a foreign country. If the
majority of a country's GNP comes from agriculture, it implies that the country is agriculture
based and it shall have a good demand for agricr~lturalinputs such as seeds, ferlilisers,
pesticides and agricultural ~nachirleryand tools. An industrial nation with relatively higher
dependcncc on ~nanufacturing,on the other hand, sllall have agood market for raw materials,
plant and machinery, and also for a variety of consumer durables and non-durables.
Though per capita income is a useful measure, it is not a full-proof measure of the country's
development and prosperity. What is more relevant is the distribution of income. While in
the developed countries income distribution is relatively more even, it is highly skewed in the
developing countries. Since only a small portion of the population accounts for 60 to 70 pkr
cent of the country's GNP and the rest are poor in the developing countries, market for high
priced product and non-essential products is limited only to select rich people.
Expenditrlre Pattern: Data on expenditure patterns are useful in judging as to how the money
is spent on different i t e m and which products receive more weiglltage.
Infrastructure: Infrastructure is another vital dimension of the country's economic environ-
ment and is directly related to the country's economic development. Infrastructure refers to
various social overheads such as transportation, telecommunications, comnlercial and
financial services like advertising, m~rketingresearch, various media, warehousing,
insurance, distribution, credit and banking facilities. Absence of adequate infrastructure not
only hinders country's development but also affects firms' costs and capacity to reach
various market segments. Companies find it difficult to co-ordinate and control their
business in countries with poor communication systems.
1.5.2 Financial Environment
Sound tinancial position of the country coupled by the favourable investment policies
reflect strong denland potential. Let us briefly learn important financial indicators.
Monetary a r ~ dFiscal Policies: Inflation, interest rate, various kinds of duties and exchange
rates are the variables related to the country's ~nonetaryand fiscal policies and have a
, Mdt~~trlna . , i t $ . .iii~atltll~pactUII the costs and profitability of business operations. These variables also
rlltltlmce u firm's decision to move funds from one nation to another.
C'!,elmcrcial and Foreign Investment Policies: Each country has its own commercial and
fairztpn investment policies which must be studied in detail to ascertain country's opellness
ttt tr,itlr! ,~ndirlvcstment with other countries. A proper understanding of these policies can
Ire rl~rrtcttslpfuj in nscertaining what tariff and non-tariff barriers the particulq country
IJ ,a) r to protect its domestic industry from foreign competition. The country m a y plan to
ndirii~niuethe incidence of these trade measures.
H~lelrceof Payments Account: A country's balance ofpayments account is another major
i,i,lrrsa of'infomation about the country's foreign trade and foreign currency reserves. The
ctrrrt.ltt ;iccoccnt throws light on the country's exports and imports as well as its major
\r41rrr cs of imports and destinations of exports. Capital account reveals stocks of foreign
nnwdftnretirs,borrowings, lending and foreign exchange reserves. An international firm
nrr+iilatic duly nwnre of exchange controls prevalent in the foreign countries. Countries
rat~ninpcfeficit5 ill their balance of payment accounts generally impose controls on rnove-
rtsnt of firreign exchange into and out of their economies. These controJs prompts the
rv~~ltin;rtiottal col-porations to resort to transfer pricing mechanism, i.e., overinvoicing of
ir~ipc~rts and underpricing of exports so as to move out more than permitted finds from
secll countries.
i standing of the language of the market -particularly the semantic differentials and idiom-
Business is as much a socio-cultural phenomenon as it is an economic activity. Per capita
income in two countries may be the same, yet the consumption patterns in these countries
may differ. Socio+culluralforces have considerable impact on pmductgpeople consume;
designs, coloun md symbols they like; dresses they wear and emphasis they place on
mligion, work, entertainment, family and other social relations. ~ocio-culturalenvironment
influences all aspects of human behaviour snd is pervasive in all facets of business ope*
tionr,
C u l l u ~CUI be defined es a "sum total of man's knowledge, beliefs, art, morals, laws,
curloms end any other capabilities and habits acquired by man as a member of society." It
is a distinctive way of life ofa group of people, their complete desi$n of living. Culfore
thus refers to a man's entire social heritage -a distinctive life sfyle of a society and its
"@.'I value system which is intricately related to Be consumption pattern of the people and
mmapanent philosophies and practices. Look at the box which gives you insight about h e
8 ~ ~ ~ c ~ I environment,
tural
I pa"icipati~e Management Sty* Backfires!
A p d u ~ l l o nmmager who had been sent to Peru from the United S t a b w u convinced
1 Malaysia where it connotes illness and death. Symbols also need to be interpreted correctly,
ha mdl'ate work^^ to higher productivity by inaituting a more democratic
'Ow
rn
'
dwiBnmrtfng *Ie- He brought in bincrs from Me home officeto teach supemi.ors
aa'icitN&edon$ a d feedback from the workem, shortly a&r he new
Ont 'Mlc wm inkoduccd, h e worken began quioing their john When uked
M'
tb' micd
whU ' (bat fie new Pmduction manager wd his supervison appamty did
weE,the~fore,&khg the worken for advice. Obviousln
UUI wmpmy
' not Imt
VUMd qU" bdf're the W l l a ~
an^ tin&
long with hat kind of management, md workers, therefon,
beawe
~ then everyone would be huntingfor a job st
lntrodllction to lnternationul
Furthermore, within each culture there are many subcultures that can liave business signifi-
Business Environmer~t
cance. For instance, in a country like United States distinct subcultures prevail in the South,
North-Eastern or midwestern parts. Subcultures are found in all national cultures and failure
to recognise them may create impressions of sameness which in reality may not exist. A
single national and political boundary does not necessarily mean a single cultural entity.
Canada, for instance, is divided between its French and English heritages, althoug11politi-
cally the country is one. Because of such distinctive cultural division, a successful marketing
strategy among the French Canadians might not effectively work among the English Canadi-
ans or vice-versa. Similarly a single personnel policy may not work with workers employed in
two different plants if they belong to different subcultural groups and differ in their work
habits and underlying motivations.
Elements of Culture 1
Some of the important elements to understand a country's culture are: language, aesthetics,
education, religions and superstitions, attitudes and values, material culture, social groups
and organisations, arrd business customs and practices.
Language: Language is an important element of culture and it is through language that most
of the communicatio~~s take place. An international marketer should have a thorough under-
atic nuances which are essential characteristics of all languages of the world. Dictionary
translation could be quite different from the idiomatic interpretation of a language. When
literal translations are made of brand names or advertising messages from one language to
another by people who know the language but not the culture, serious mistakes ntay occur.
When General Motors of tlie United States literally translated its marketing phrase 'Body by
Fisher' into Fle~nislllanguage, it meant 'Corpse by Fisher'. Similarly, the phrase "Come
alive with Pepsi" faced problems when it was translated into German advertisements as
"Come out of grave" or in Chinese as "Pepsi brings your nncestors back from the grilve".
When the American car called 'Nova' was introduced in Puerto Rico, sales were poor until
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the company realised that the word Nova was pronounced as 'Nova' which literally meant
in Spanish "does not go". Sales were better when the name was changed to 'Carbie'.
Aesthetics: Aesthetics pertain to a culture's sense of beauty and good taste, and is ex-
pressed in arts, drama, music, folklore, dance and the like, Aesthetics are of special interest to
the international business executives for these govern tlie norms of beauty in a society and
are helpful in correctly interpreting meanings of various methods o f artistic expressions,
colours, shapes, forms and symbols in a particular culture. Colours, tor instance, mean
different things to different people. The colour of mourning is black in the United States, but
it is white in the Far East. Green is resthl colour to Americans, but it is disliked by people in
Seven, for instance, signifies good luck in the United States but just opposite in Singapore,
~ h a n aand Kenya. Use of number four should be avoided in Japan because it is pronounced
as 'shi' which in Japanese means death. Sensitivity to the aesthetics of a society and their
symbolic expressions can greatly help in avoiding socially embarrassing situations and .
correctly designing the products and messages.
Education: Education is generally understood as formal schooling. But it is better to adopt
a broader perspective and define education as any process, formal or infonnal, through
which one learns skills, ideas and attitudes. Education is important as it affects not only the
education levels but also the development of mental faculties and various skills, In general,
educated people have been found to be more sophisticated, discriminating and receptive to
new products and ideas. Availability of educated manpower like skilled labour, technicians
and professional is also dependent on the country's education level. Media to be used by a
company for promoting its products an$ services are also dependent on education level
prevailing in the country. The conventional forms of printed communications, for instance,
do not work in countries where literacy rates are low,
Religions and Superstitions: Religions are amajor determ,inant of rnotal and ethical values
and influence people's attitudes, habits and outIook on life which are reflected jn their work

lli\hbitsmd consumption patterns. Dr. Ernest Dichter observed: "In puritanical cultures, it is
castornary to lhink olsleanliness as being next to godliness. But in Catholic and Latin
American countries, to fool too much with one's body to overindulge in bathing or toiletries,
llas the.oppositemeaning. It is that type olbehaviour which is considered inlmoral and
improper".
'I'l~ereare nun~erousreligions and faiths in the world, with prominent ones being : Animism,
Buddhism, Christianity, Hinduism, Islam and Shinto. Each one has its own morals and codes
of conduct. A working knowledge of the religions prevalent in the target markets helps in
understanding people's work habbits, underlying motivations and consumption behaviours.
Equally impor-tant are the superstitions of the people in a society. People's beliefs in astrol-
ogy, hand reading, ghosts, lucky days and places are integral part of certain cultures. In some
countries, single storey houses are preferred because it is considered bad to have another's
foot on ones head. Location of a building and its architecture in many Asian countries is
governed by the principles of 'vastushastra' rather than purely geographical and econo~nic
considerations.
Attitudes and Values: Besides religions and superstitions, one must be cognisant of atti-
tudes, values and beliefs prevalent in a society. These attitudes and values may relate to
consumption level, material possessions, risk taking and change. 'What is important and
desirable' differs from society to society and is largely governed by the attitudes and ~ a l u e s
existing in a society. Americans in general are more receptive to change and risk taking, but
people in many societies are averse to change and risk taking. They prefer doing what is
traditional and safe. New products are not accepted unless these have the approval of local
chiefs or religious leaders.
behavioural nornis, codes of social conduct, value systems, etc., that may be of relevance to lntroductior~to lnternntional
Busincss Environment
the i~lternationalbusiness managers in their decision making.
Busia~essCustotms and Practices: A familiarity with business customs and practices preva-
lent in different countries is a must to avoid business blunders. An international business
n-nanager must have necessary knowledge about how business is col~ductedand what
importance business people in a foreign cou~ltryattach to work, time, formality, change and
achievement. American managers, for instance, are by nature highly work oriented and attach
upmo:;!. i~nportni~r"~:
ro spced and punctuality in business dealings. They are, moreover,
highly acliievcll~i:nt oriented and fond of new things. But people in other partsrof the world
do not share these values and beliefs. Japanese, for instance, are also workaholics but they
.are very slow in decision makingl'latin Americans too do not believe in haste and spend
considera1.de time in socialising and developing friendships before coming to business
transactions.
A person dealing with people from different cultures should be well aware of differences in
the number and nature of stages involved in business negotiations ancl formalities to be
observed in concluding business contracts. While in countries like the Ullited States it is
necessary to have final agreement in writing, this practice is not rnrlch appreciated in many
West Asian countries where oral agreement alone is considered more than sufficient.
Check Your Progress B
1. What is economic environment?

Material Culture: According to Ball and McCulloch, material culture refers t o all nian-
made objects and its study is concerned with how man makes things and who makes what
and why. While the question 'how7 relates to technology, other questions 'who', 'what' and
'why' are part of economics.

Technology includes the ways and means applied in making of material goods. It is technical
know-how in possession of the people of a society. Choice oftechnology I~asits repercus- 2. Distinguish between Current Account and Capital Account.
sions 011 the size of investment, scale of operations as well as type and Amber of workers to
be employed. Tkchnology transfer has been a highly controversial issue in the past. Because
of supply of obsolete or inappropriate technology, many developing countries have laid
down stringent rules and regulations concerning technology import$ and payments. Since
transfer of new technology is often riddled with workers' resistance to change and public
criticisms, multinational corporations are advised to have suitable action plans to counter
such opposition.

Economic aspects of material culture, i.e., who, what and why, have already been discussed 3. Enumerate four elemellts of culture,
in Sub-section 1.5.1. It is suffice to say here that these elements influence the leveI of
demand as well as types and quality of goods in demand, and consumption pattern in a
society.

Business implications of material culture of a society are obviously many. The goods and
services that are acceptable in one market may not be acceptable in another market because
of differences in material cultures of two societies. For example, sophisticated electronic
appliances widely in demand in the technologically and economically advallced Western
countries may not find a market in the less developed countries of Asia, Africa or Latin
America. '4. What is material culture?

Social Croups and Organisations: A study of social goups and organisations is i~nportant
as it determines how people relate to one another and orgmise their activities. The size and
cohesiveness ofthe family, role ofmen and women in society, and positions of different*
s a c i ~classes
i differ from country to country. Social groups and organisations mould the
pattern of living and interpersonal relationships of people in a socieo. They influ&ce the

i:onrcpts H I I ~Dimensior~s
5. State whether following statements are True or False.
Different climatic conditions give rise to demand for different types of
products.
ii) Demand for consumer products depends on Gross National Products.
iii) Per capita income is a fullproof'measure of the country's development and
prosperity.
iv) Countries running deficits in their balance of payment accounts generally
impose controls on movement of foreign exchange into and out of-their
economies.
v) Green connotes illness and death in America.
1.7 POLITICAL ENVIRONMENT
It is rightly said that a foreign business firm operates only as a guest and at the convenience
of the host country government. The government reserves the right of allowing a foreign
firm to operate in the country as well as laying down the manner in which a foreign firm
can conduct business. To gain an insight into a foreign country's political environment, one
needs to analyse factors such as current form of government and political party system, role
of govemment in the economy, political encouragement to foreign firms, political stability,
and political risks to business.
Form of Government and Political Party System: Government in a foreign country can be
either parliamentary or absolutist. While the parliamentary type of government is run by
people's representatives selected from time to time, the absolutist government assumes the
f o w of absolute monarchies or dictatorships, and only a select few make policies. In the
case of parliamentary government, one needs to know whether it is a single party system or
multiparty govemment system. Single party government is considered to be more stable
I
than the multiparty government.
I business decisions like location of plant, level of production, employment of people, raising
Political Ideology and Role of Government: Besides political party system, one must have
knowledge about the political ideology and government attitudes toward foreign business
and investment. In addition to regulatory role, government itself can be directly involved in
business. In such cases, government enterprises emerge as dominant players in the market
and pose tough competition to the foreign firms. Even supplying goods and services to the
agencies is not hassle free. Because of monopsonic power of the government
organisations, it becomes quite arduous to negotiate prices and other terms with them.
Political Stability: Stability of the government and government policies are a major concern
for the international firm. Since business decisions, these days involve huge investments and
are irreversible, what the foreign firms look in for is politically stable countries. Political
instability can result from either change in the type of government, a shift ip-political parties
that form the government or change in the government policies without cl(ange in the
government or shifts in political parties.
Political Risk: Political risk which is defined as the vulnerability of a project to the political
acts of a sovereign government is a big threat to foreign business. The political acts leading
to political risks can range froni confiscation, expropriation, nationalisation,domestication to
restrictions on transfer of finds. Confiscation occurs when a foreign investment is taken
over by a govemment without any compensation. Expropriation takes place when the
,govehment takes over foreign investment but some compensation is paid. The compensa-
tion may or may not equate with the market value of a fum. Nationalisation affects the entire
industry rather than a single company, and involves transferring ownership of the confis-
cated or expropriated business to a national firm or government entity.
Domestication is a mild form of intervention and involves transfer of control of foreign
investment to national ownership to bring the firm's activities in line with national interest.
It differs from expropriation in the sense that it is gradual encroachment of the freedom of
I law.
16 operation of a foreign operator. Domestication can be either firm initiated, governrhent
Introduction
Business illternationa'
to Environment
initiated or predetermined. Whereas firm lnltlated and predetermi~ieddomestication entail low
levels of risk, government initiated domestication is quite risky and is ranked with expropria-
Another type of risk relates to a temporary or permanent blocking of finds. Unlike other
kinds of risks, a business firm under blockage of funds owns the funds and property rights
but it cannot remit the funds or earnings back to home country. This was a common
problem faced by Indians during Amin's rule in Uganda, Although the government did not
formally ~nakeany announcements regarding takeover of property, it became almost
impossible for the firms to repatriate their earnings in any form. No doubt black money
market operations may exist in any country, it is difficult for such operations to handle
large scale of funds involved.
I International firms need a proactive approach to deal with political risks. An effective
management of risks calls for recognising the existence of various kinds of political types
of risks and their consequences, and developing appropriate plans and policies to deal with
1 such risks. . .
i 1.8 LEGAL ENVIK~NMENT
Every business firm operates within the jurisdiction of legal system. This is true of domes-
tic as well as intematiollal firms. But the problem for the international finns is that the
laws that they face in their home countries might be diEferent from those encountered in the
host countries. Advertising Iaws in West Germany, for instance, are so strict that is best
advised for the international marketer to get himself good legal counsel before framing his
advertising strategy in West Ge~many,Similarly there exist laws in Eoropean countries
preventing promotion of products through price discounting. These laws are based on the
premise that such practices differentiate buyers,
Different Iaws exist not only in the area of marketing mix variables but also for other
money from the market, accounting and taxation, property rights incIuding immovable
,property and patent and trade marks, cancellation of agreements.
Besides directly influencing firm's busin&s operations, laws affect the environment
within which a firm operates in the foreign country, Tlius while one country may promote
competition within its markets through its legal system, another country might try to
protect its industry and thereby restrain competition. In the United States, for instance,'
anti-trust legislation influences all mergers, take-overs, and business practices which we in
restraint of trade, Court's verdicts in this respect are governed by paragraph one of
Sherman Act. Gillette, for example, was prevented from taking over Braun A.G. of West
Germany which was an electric razor manufacturer on the grounds that it ~voulddistort
competition.
A major problem with laws in different countries is that the legal systems of the world are
not harmonised and are in fact based on contradicting legal philosophies. The legal systems
that exist in different countries of the world are antecedents of one of the two legal philoso-
phies ,viz., common law and code law. Common law finds it roots in Britain and is
practised today in the United States, United Kingdom and Canada. The basis of common
law is tradition, past practices m d past rulings of higher courts who look upon similar
problems within the accepted set of laws. Code law, on the other hand, is based on Roman
law and is an all inclusive system of written rules that encompass all eventualities. One
important business implication of the two legal philosophies is that the judgements
awarded in the case of a commercial dispute can be radically different. To illustrate, let Us
take the interpretation of non-fulfilment of required conditions of a contract under 'act of
god'. h a t constitutes an 'act of god' in code law is not necessarily the same under
common law. Thus while strike by workers may be looked upon as an 'act of god' in code
law, it will definitely not be a reason for non-fiiirlfilment of the contract under the common
 1
I

('o~~rcptsid I ) i ~ n c ~ ~ s i o n ~ In last few decades, efforts have been made to evolve international laws, International laws 1 lntroductif~nto lntcrnntiona
1 2. Distinguish between confiscation and expropriation. Buslness Environmen
deal with upholding orders. Originally these laws recognised only nations as entities, but
today these laws also incorporate role played by individuals. International laws ma; be 1I ............................................................................................................
defined as a set of rules and regulations which the nations consider binding upon them 4
I

selves. This definition brings out two important characteristics of international law. One I

there is absence of the existence of a comprehensive legal system. There is truly no compre- <
hensive body of law because as stated earlier international commercial law is of recent I

birth. This has had a direct bearing upon the existing administering authorities. As of L
I
today, there are only a few international bodies for administeringjustice. These include I

lnternational Court of Justice founded in 1946 and the World Court at Hague. Second
cllaracteristic of the international law relates to tlie fact that no nation can be forced into
i
r 3. What do you mean by domestication?
these rules as stated in the phrase 'consider binding upon thenl'. Since all nations
recognise the sovereignty of the legal systems, international judgements are, therefore,
based on the premise of good humanity and not on the basis of any particular country's
legal system. I
t

In the absence of laws having jurisdiction over sovereign countries, a major problem faced
by the international business~firmsis which country's laws, viz.. hon country's or home '
countly's or third country's laws, shall be binding in the case of a dispute. Firms also need
to be aware of differentmodes of the settlement of trade disputes and role of lnternational
4. What is international law?
Chamber of Commerce' Court of Arbitration.
............................................................................................................
Because the field of international law is wide, in this sub-section we have made only an
attempt to highlight some of the major legal issues. A detailed discussion of various legal
aspects is provided in Units 14 to 16.

1.9 ECOLOGICAL ENVIRONMENT

5. State whether following statements are True or False,
i': : Ecology refers to the pattern and balance of relationships between plants. animals, people
i) The nbsol~~tist
government assumes the form of absolute monarchies or
and their environment. Earlier there was hardly any concern for the depletion of resources
dictatorship.
and pollution of the environment. Smoke stemming from the chimneys and the dust and
grime associated with factories were accepted as a necessary price to be paid for the devel- ii) , Government initiated domestication is not risky.
opment. But in recent years, the magnitude and nature of the 'pollution overload' have
iii) Advertising laws are very strict in West Germany.
assumed such alarming proportions that pressures have built up all over the world to do
something urgently lest the situation gets out of control. In almost all the countries, there iv) In the United States, anti-trust legislation influences all mergers, take-oven
exist today legislations and codes of conduct to preserve the earth's scarce resources and and business practices which are in restraint of trade.
put a halt to any further deterioration in the environment. ~usinesdo~erationsof the Germany lias relaxed environtnental laws.
v)
international firms are no exceptions and have been brought under such regulations. Very
recently, the United States government imposed a ban on expbrts of marine products from
countries including India which did not have special devices fitted into fishing trawlers to
free the tortoises trapped during fishing expeditions. Similarly, restrictions have been put 1.10 LET US SUM UP
on garment exports using cloth processed through the use of AZO dyes. Germany today is
perhaps the country with most stringent environn~entallaws in the world. A major difference between domestic and international business is the environment within
which business is conducted, While doing business within one's own country, one is
The concept of industrial progress and development has also undergone paradigm sbifts. familiar with the prevailing environment and is readily able to adjust to it. But problem
Corporations today are judged in terms of not only financial returns, but also conservation with doing business in foreign countries is that environments in foreign countries are
of environmental resources and reduction in pollution levels. Green technologies, green different and also unfamiliar to a business firm. Because of environmental differences,
products and green companies are highly valued in today's global market place. strategies a firm uses in the home country might not be appropriate in the foreign coun-
vies. One, therefore, needs to be extra careful in identifying various environmental forces
.%heckYour Progress C operating at the home country, host country and global levels; and should examine their
influence on production, personnel, financial and marketing operations of the firm.Tho
. . 1: What is political instability? ~najorforeign environment to be analysed include; geographical, economic, financial, socio-
cultural, political, legal and ecological.
.......................................................................................
I '
'""""""'?"'~.." ...""".'."..'.."'...'.."'.'......r.,......,.......:............................. 1.11 KEY WORDS
,
I

I
....."..."..... 1................1......................,..~.....,,.,,.,..,.,.,..,.,.,...,..,,...,......
Business environment: Various external actors and forces that surround a business firm and
influence its decisions and operations.
 NIlCrO envikortrrrent: Actors in the firm's ln~rneaiateenv~ronmentsuch as suppliers, various
markeling intermediaries, services organisations, competitors and customers which dircctly
influence a firm's decisions and operations.

Macro environment: Broader geographic, economic, financial, socio-cultural, political, legal

and ecological forces in the firm's envi~onlne~it
which affect the firm as well as other actors in Structure
the firm's micro environment. These forces can operate at the home (i.e.,donlestic) country,
hast (i.e., foreign) country and global levels.
Ob.jectives
Introduction
Geographic environment: It refers to a country's climatic conditions; topographic features Ob.jectives of Trade Theories
like size; location, hills, rivers and access to sea; aatul-al resources and people.
Ricardian Theory of Trade
2.3.1 Labour Theory of Value
Economic and financial environment: It pertains to country's economic and financial features 2.3.2 Autarky Equilibriuni
Such as level of economic development, income, pattern of expenditure, init-astructure. 2.3.3 Ahsolutc Advantage versus Comparative Advantage
inflation, commercial and foreign investment policies, monetary alld fiscal systems, account- 2.3.4 Free Trade and Chins from I'radc
ing systems and balance of paynlents account. 2.3.5 'l'esnis of ' h d c
The Neoclassicsl 'Theory of Trade
Cultural Environment: Culture is defined as the sum total of man's knowledge, beliefs, art, 2.4.1 Relative F:ictor Abundnnce
murals, taws, C U S ~ ( I ~and
S any other capabilities and habbits acquired by man as a member of 2.4.2 Factor Intensity
the society. 2.4.3 The Assunlptions of the Neoclassical Modcl
2.4.4 produet Price Ratio and Factor Pricc Ratio
Political rislcs: Political risks refer to vul~ierabilityof a prqject to the political acts of a 2.4.5 The Heckscher-Ohlin- Samuelson (HOS)'Theorem
sovereign government. 2.4.6 Factor IJriccEqualisation I'heoreni
2.4.7 !$runuelson-Stolper'rheorem
Ecology : it reFers to pattern and balance of relationships between plants, animals, people and 2.4.8 Ryhczynski Theorem
their environment. Modern Theories of Trade
Let Us Sum Up
Key Words
Answers to Check Your Progress
1.12 ANSWERS TO CHECK YOUR PROGRESS Terminal Questions
5 i) True; ii) False; iii) False; iv) False; v) True.
A
- -----. --

B 5 i) True; ii) False; iii) False; iv) True; v) False. 2.0 OBJECTIVES
- - - -.

After studying this unit, you should be able to:

1.13 TERMINAL QUESTIONS m describe the pattern of trade between two countries
0 discuss how international trade is nlutually beneficial to the trading countries
1. Define international business environment. Also differentiate between micro and
macro environments. e explain the classical theory of trade
2. How does the home country environment influence foreign business operations of a describe the neo-classical theories of trade
firni? Explain. 0 describe the niodern theory of trade.
3. How econonlic environment affect the business decision of a firm?
4, Discuss important elements of culture and their impact on a firm's international
business operations. -
2.1 INTRODUCTION --
5. . What IS political risk? What are the major types of political risks? Discuss. Foreign trade has recently, and particularly after 1991, become an important as well as
6. Why should an international business firm monitor the foreign country's trade, debatable issue for the lndian economy. The Union budget presented in 1991 introduced a
monetary and balance of payments account? wide range of economic policy reforms related with industry and trade, ushering in an era
of ccono~nicliberalism in the Indian economy. These reforms were designed to transform z
closed and inward-looking economy into an open and outward-looking one by lifting
controls on import and export of goods and services and by making rupee convertible, Jn
the years that followed, our trade and industrial production have been growing at fairly
I high rates. There is no doubt that the liberal approach to economic policy will continoe
and the previous bias against international trade and investment will remain subdued in the
foreseeable future. In this new economic environment thf,teachingof economics will
develop a serious gap if the students are not made awal-e of the basic principles ond con-
cepts of international trade. In this unit, you will learn the concept of absolute and com-
parative advantage, gains from trade, terms of trade and various theories of intematione
trade.
 [he relative price of cloth in t e r m of wheat is 3WfSW or 315 which simply means that 315 tll
Conccpts and Dimensions of a unit of wlieat will buy one unit of cloth, or 6 kg. wheat will exchange for one yard of Theories of
'
2.2 OBJECTIVES OF TRADE THEORIES lnternrtionrl Trndc
clotli. In the terminology of classical economists this exchange ratio is known as value which
The purpose of a trade theory is to explain the pattern of trade between two countries. What is determined only by labour and nothing else.
is meant by pattern of trade? Suppose India exports garments, gems and jewellery and a few
other products to the United States , while the latter exports computer parts, such as hard 2.3.2 Autarky Equilibrium
disks, and other machines to India. This pattern of export and import of goods is known as
the pattern of trade. The theory of international trade explains why such a pattern emerges YOU should understand the importance of the labour theory of value. We are dealing with two
and lists the facton which cause such a pattern. Trade between two nations is not just in markets simultaneously and therefore it is in the general equilibrium framework. The labour
goods. Trade in services is also quite important. If the United States provides banking and theory of value gives a simple explanation of how the relative price oftwo goods is deter-
insurance services to theIndian citizens, say to the Indian exporters and importers, and if mined. Since we do not intend to introduce money in the model, it is the relative price or the
.these are provided from the United States, then it is to be regarded as the U.S. export exchange ratio which will determine the production and demand in the two industries. We
of services to India. There are two main theories on pattern of trade: the classical o r the would of course assume that the labour requirements peC unit of wheat or cloth (5,3) remain
Ricardian theory and the neoclassical theory or the Heckscher-Ohlin-Samuelson theory. the same, no matter how many units of the two goods the economy produces. This assump-
of trade theory is to explain the pattern of specialisation. A pattern of tion is known as the constant returns to scale (CRS). CRS means that the labour
The second productivities are independent of the scale of output. What are the labour productivities in
specialisation tells us the kinds of products and their quantities z i country would produce. In
cloth and wheat production ? These are 113 and 115 respectively, one hour of labour will
the above example, India would produce garments, gems and jewellery and other products
produce 1 /3 yard of cloth and 115 x 10 = 2 Kg. wheat. Labour productivity is just the recipro-
and the United States would produce computer parts and other machines. India may or may
cal of the unit labour requirement. With 300 hours of labour available and filly employed at
not produce computer ports and machines which USA would produce and similarly USA
one time in an economy, the production possibility frontier is.shown as AB. Look at Figure
may or may not produce garments and the gems and jewellery. The pattern of trade and the 2.1 which shows production possibilities of wheat and cloth. Notice that if all labour are
pttern of specialisation will depend on the model you are using to explain these patterns. If
devoted to the production to cloth, then 100 units of cloth will be produced and that if all
you are using the Ricardian theory then you come to the conclusion that USA would not
labour go into wheat production, then 60 units of wheat will be produced. Thus the slope of
produce garments or gems and jewellery in which India has specialised. But if you are using
the production possibility frontier is 6011 00 = 315 which is the exchange ratio. In autarky the
the neoclassical theory then you would say that USA would produce the goods it is import-
economy's consumers will choose a point like P on the production frontier in such a way that
ing from India. The domestic industries that produce the goods that the country impofls are I
their welfare is maximised. 'Thus in equilibrium, OW and OC are the quantities of wheat and
known as import competing industries (e.g. garments for USA colnputer parts for India) and
cloth respectively, both demanded and supplied. The point P, in other words, represents a
those producing goods that the country exports are called export industries (e.g. computer
general equilibrium in the economy where demand and supply in each ofthe two markets are
parts for USA and garments for India). A country however will have industries whose
equal.
products are neither exported nor imported and the goods produced by them are called non-
- traded goods, such as domestic transportation, electricity, etc.
Figure 2.1: Production Possibilities of Wheat and Cloth
The third objective of trade theory is to show that international trade is mutually beneficial to
the trading countries. A country which is not engaged in trade with any country is in a state
of autarky. The theory says that trade is better than autarky under any circumstances.
However, how much trade a country should have and whether :I country should restrict the
quantities of exports and imports by custorns duties, tariffs, quotas and taxes is quite another
matter. These issues come in the category of trade policy which will be discussed in Unit 4.

2.3 RICARDIAN THEORY OF TRADE

0 C 100 Cloth
Ricardian theory of trade focusses on the co~nparativeadvantage of the nation. Let us
discuss them in detail.

2.3.1 Labour Theory of Value 2.3.3 Absolute Advantage Versus Comparative Advantage
~ l ~econol~ists,
~ ~ such i as~ David
~ Ricardo,
l believed that labour is the only Source of v d u c
let us look at another economy where the unit labour requirements are somewhat
of goods in the economy. This does not llXiln that no other inputs are required i n
different because of an improved technology. We assume that 1 and 4 hours of labour
production, but since the other inputs such as mW materials and capital gmds are also
produce respectively one unit of ~10thand one unit ofwheat, Since less labour is required
produced by labour, it is the h h u r which determines the relative valuation of
lo produce one unit of each good in the second country (call it a foreign country I), it has
goods, Anlong other inputs, not produced by labour, land is given by nature in a fixed
.what is called an absolute advantage over the'first country (call it the home country). so
quantityLandowners earn rent which does not determine price, rather it is the price which
there 1s no trade between the two countries. But suppose there is trade now and would it
determines how much rent the landowners will earn. Such an explanation is known
be 'Orrect to say the foreign country has no incentive to trade because it is efficient in
as the labour theory of value, Let us understand it with the help of an example. Assullle that
both goods, whereas the home country is too eager to trade because it is inefficient in the
it takes 3 hours of labour to make one yard of ~10thand 5 hours of labour to 10 kilograln of
productionof both goods? The answer is that the so-called absolute advantage does not
wheat. The wheat and cloth markets are perfectly competitive and labour is free lo move from
deterlninethe Pattern of trade between two countries. It is the chparative advantage
to cloth production and vice versa. This implies that the wage rate will be which is relevant.
same in the cloth and wheat industries. Let W be this Wage rate. Then the average
(cost per unit, one unit of cloth is one yard and one unit of wheat is 10 Kg in cloth and But what is comparative advantage? In home country 3/5th ofa unit of4hcst is exchanged
wheat pmduction will be nspectivdy 3W and 5W.These will also be the prices of cloth and
I
Thus , for Ona unit of cloth and in the foreign Muntry 1/4 of a unit of wheat will exchange for one
22 wheat respectively, because under perfect competition piice is equal to average *lmitof cloth. Since 315 > 114, ~10this mote s x p w i v e in m s of wheat in the home c o u n ~ 23
L-
 than in the foreign country. Thus the foreign country has con~parativeadvantage in cloth
production. But home country has comparative advantage in wheat production because here
513 units of cloth will exchange for one unit of wheat which is less than 4 units of cloth
which will exchange for one unit of wheat in the foreign country. Thus, though the foreign
country has an absolute advantage in both goods it has comparative advantage in only one,
namely cloth. The home country has absolute disadvantage in both goods but it has a
comparative advantage in wheat. But what determines comparative advantage?
In order to answer this question let us find the labour PI-oductivitiesin the two countries in
cloth and wheaiproduction. Look at Table 2.1 which shows the comparative labour
productivities in both countries.
Table 2.1: Labour Productivities
As you remember, labour productivities are just the reciprocals of unit labour requirements. If
we compare the ratios of the latjour productivity in $loth to that in wheat production we see
that the foreign country has a, higher ratio (4 1513) and therefore it is relatively more produc-
tive in cloth. On the other hand, if we compare the ratios of labour productivity in wheat to .
that in cloth production, the home country has a higher ratio (315 > 114) which shows that the
home country is relatively more productive in wheat. Thus, the Ricardian theorem on trade
pattern states that a country lias comparative advantage in the good in which its relative
labour prodlrctivity is higher than its trading partner and tends to export this good and tends
to import the good in which its trading partner hascomparative advantage.
As regards the pattern of specialisation the Ricardian theory states that a country completely
specialises in the good in which it has compa\ative advantage. In the above example the
home country will produce only wheat and the foreign country only cloth because the
relative labour productivity is assumed to remain constant. Obvionsly, with no change in
labour productivity, the country will put all its labour in the production of the good in
which its labour is relatively more productive. If this theory is taken to be true, then no
country will have an import competing sector because the imported goods will not be
produced at all in the countly.
2.3.4 Free Trade and Gains from Trade
The countries will not trade with each other unless trade makes them better off. What we
can show here is that free trade is always better than no trade. In course o f this discussion
we will further explain why in the Ricardian system the specialisation is complete. Our
starting point is the exchange ratios or values in the two countries in the pre-trade situa-
tion. For the home country the exchange ratio (3/5 unit of wheat exchanged for one unit of
cloth) is the slope of the production possibility frontier in Figure 2.1. One rnay draw a similar
diagram for the foreign country and the slope of its production possibility frontier will show
the exchange ratio as 114 unit ofwheat for one unit of cloth. But there is another aspect of
Figure 2.1 which has not been fully explained and this is the indifference curve drawn as a
dotted curve, tangent to the production possibility frontier. At the equilibrium point P, the
I
marginal rate of transformation (MRT) which is slope of the production possibility frontier
gives the rate at which wheat can be converted into cloth by shifiing labour from wheat to
cloth. This is again the same as the exchange ratio. The slope of the indifference curve
measures the marginal rate of substitution (MRS) or the rate at which the consumers will
substitute wheat for cloth. At P,MRT=MRS= 315. For the foreign country MRT=MRS=l/4,
24
I,et LIS ilssLlliie ~liatthe two countries have no trade with each other. Now suppose that the 'I'heorics of
home country shifts labour from cloth to wheat to produce an extra 315 unit of wheat at the lnterrintional Trndc
cost of one unit of cloth. But this loss of one unit of cloth can be more than compensated
through trade with the foreign country where only 114 unit of wheat is required to buy one
unit of cloth. In this exchange the home country gains from trade. Since trade is gainful,
the home country will keep on reducing the production of cloth and increasing the produc-
tion of wheat till it produces only wheat and complete specialisation occurs. But will the
foreign country also gain? We will soon find out.
Theory of conlparative advantage provides the basis for trade. When two countries are
autarkies, there are four markets : markets for wheat and cloth in the home country and the
markets for wheat and cloth in the foreign country. If trade is free, there are no tariffs or
quotas or any olher kind of restriction on the movement of goods between the two coun-
tries, then the four markets get integrated into two markets : one world market for wheat
and one world market for cloth. The exchange ratio between cloth and wheat will be
deter~ninedin the world markets. What will be the exchange ratio when the world markets
are in equilibrium? We can argue that it will lie between the exchange ratios in the two
countries in the pre-trade situation, i.e., between 114 and 3/5 which are simply the prices of
cloth in terms of wheat in the foreign and home countries respectively, Since the foreign
country is exporting cloth tlie pressure of home country's import demand for cloth will
raise tlie price of cloth 114 to say 215. In the home country the opposite will happen. Since
it is an importer of cloth, the foreign supply will keep adding to domestic supply and
reduce the price of cloth from 315 to say 215. In other words, we are assuming that the
equilibrium exchange ratio will be 215 in the world markets. Remember that in free trade
the two countries will pay the same price for any good and the law of one price has to hold.
Now we can make a co~nparisonbetween free trade and no trade, assuming that in free
trade both countries can exchange 215 unit of wheat for one unit of cloth. Remember that
this exchange ratio was 315 in the home country and 114 in the foreign country before
trade. It is now easy to see that home country will gain by reducing the production of cloth
and importing it and the foreign country will gain by reducing the production of wheat and
importing it. If the home country reduces cloth production by one unit, it can increase
wheat output by 315 unit. But out of this 315 unit of extra wheat the home country can
export 215 unit to the world market and import one unit of cloth in exchange. The con-
sumer who lost one unit of cloth will get it back through import with country and the
country will end up with a surplus of 115 unit of wheat. If the foreign country reduces the
productio~iof wheat by one unit, it can increase tlie production of cloth by 4 units. In the
world market 512 units of cloth will exchange for one unit of wheat. Thus the foreign
country recovers the loss of one unit of wheat through import and has a surplus of 3/2 units
of cloth. Thus, free trade benefits both countries who tend to specialise completely in the
goods in which lliey have comparative advantage.
2.3.5 Terms o f Trade
The definition of commodity terms of trade is the price of one good in terms of the other. I
In autarkies tlie home country's terms of trade was 315 unit of wheat for one unit of cloth ,;I
whereas the foreign countries ter~nsof trade was 114 unit of wheat for one unit of cloth. As
we have just argued, the equilibrium terms of trade in the world markets will be somewhere
between 114 and 31.5 and we have assumed that it is 215. In the context of trade, the terms
of trade is the price of the exported good in terms of the imported good. Since the home
country is an exporter of wheat, its terms of trade is 215 unit of wheat for one unit of cloth.
But for the foreign country which is a cloth exporter the terms of trade is just the reciprocal
of the home country's terms of trade, i.e., 5L?units of cloth for one unit of wheat.
International trade will not only change the autarky terms of trade of the two countries and
bring them together at a common level, it will also change the relative wage rate, The ratio
between the home country's wage rate and the foreign country's wage rate is known as the
factorial terms of trade. The meaning of factorial terms of trade is number of hours of one
country's labour that will exchange for one hour of the other country's labour. But one has to
be carefi!I ill interpreting this concept. There is no exchange of labour between the two
 countries, there is only an exchange of goods. But goods embody labour hours spent in thei
production. Thus, trade determines factor terms of trade indirectly.
We have just seen in the above that the commodity terms of trade will lie between 315 and I/
4. Can we find such limits for the factorial terms of trade? The answer is yes and the limits for
the factorial terms oftrade are 113 and 415. To prove this let us assume that W,, and W,are
respectively the wage'rates in the home and foreign countries measures either in terms of
wheat or in t e n s of 210th.In the foreign country which has comparative advantage in cloth
the average cost of cldih must be less than the home country's average cost of cloth. This is
precisely why the home firms do not produce cloth. Since this average cost is W, in the
foreign country and 3 W,, in the home country, W, < 3 Wh or WhIW, > 113 (remember that I
and 3 are respectively the number of hours of labour required to produce one unit of cloth in
the foreign and home countries). Since 4 and 5 hours of labour are required to produce one
unit of wheat in the foreign and home countries respectively and since the home average
cost in wheat must be less than the foreign average cost, we must have 5W, < 4Wf, or Wh/
W, 415. This shows that the factorial terms oftrade will lie between 113 and 415. These
numbers can be located in the table above giving labour productivities where 113 is simply
the ratio of labour productivities in the two countries in cloth production and 415 is the ratio
of labour productivities in the two countries in wheat production.
Check Your Progress A
1. What is comparative advantage?
2. Distinguish between absolute advantage and comparative advantage.
...........................................................................................................
3. What is terms of trade?
I 2.4.3 The Assumptions of the Neoclassical Model
............................................................................................................
............................................................................................................
4, State whether following statements are True or False.
Constant returns to scale means that the labour productivity are independent
i)
of the scale of output.
ii) The absolute advantage determines the pattern of trade between t k d :
countries.
iii) Free trade is always better than no trade.
iv) Theory of comparative advantage provide the basis for trade.
Trade does not determine factor terms of trade indirectly.
v)
Theories a
2.4 THE NEOCLASSICAL THEORY OF TRADE International %ad'
The neoclassical theory focusses on the factor abundance, which determines the pattern of
trade. Let us discuss the theory in detail.
2.4.1 Relative Factor Abundance
The pattern of trade in the Ricardian theory depends entirely on the technological differences
between two trading countries, as reflected in their respective labour productivity ratios. It
does not depend on how much labour each country has. The neoclassical theory, on the
other hand, focuses on the latter aspect, namely factor endowments. In contrast to the
Ricardian theory the neoclassical theory assumes that there are at least two factors, say
labour and capital which are used in the production of goods. But the two countries have the
same technology or the same production functions. They differ only in respect of relative
factor endowments : one country being relatively labour abundant and the other relatively
capital abundant. If K is the total supply of capital and L the total labour supply, then [ WL],
> [KL], implies that the home country is relatively capital abundant and the foreign
country relatively labour abundant. This is called the physical definition of relative factor
abundance. There is an alternative definition. If the foreign country is relatively labour
abundant, then labour must be relatively cheaper there. In other words, if w is the wage rate
and r the rental of capital, then [w/r], > [wlr], would imply that the home country is relatively
capital abundant, or relatively scarce in labour endowment and would therefore have a
relatively higher wage rate. One should note that the second definition does not necessarily
follow from the first. The reason is very simple. A country may be relatively scarce ill labour,
but this does not necessarily mean that the relative wage rate will be high because it is quite
possible that there is very little demand for the goods that require the use of labour inten-
sively. Similarly, in a country where lnbour is plentiful, wage rate may be still very high
because of extremely high demand for the goods in which labour is used intensively. The
lesson that we learn is that it is not possible to determine the price of a factor only by looking
at its supply. One has to look at the demand side also.
2.4.2 Factor Intensity
Since at least two factors are needed to produce goods, it is necessary to look at the relative
intensity of factor use. Let X and Y be the quantities of the two goods and L and K be the
labour and capital used in their production. Let Kx and Lxbe the capital and labour used in
the production of x and let Kyand Lybe the capital and labour used in the production of Y.
If KxI Lx > K,,l Ly,then X is capital intensive and Y is labour intensive. In general, the
capital labour ratios will be different for different goods. For example we would expect the
production of gems and jewellery to be labour intensive and computer hardware to be capital
intensive.
The neoclassical theory makes the following assumptions:
i) Perfect competition
ii) Constant returns to scale which means that if labour and capital inputs are doubled,
output is also doubled. As a result of this assumption that average cost of
production becomes independent of the level of output that is produced. For
instance, the avernge cost of X is (wL, + r k,) I X which can be written as w (LxI X ) '
+ r (KxIX). The firms will change labour output ratio or the capital output ratio if and
only it'the wage rate changes relative to the rental price of capital in order to
~ninimisecost. But if output changes, labour and capital inputs will change in the
same proportion as output, keeping Lx/X and Kx/Xconstant. Thus, the average
cost will not change when output is changed, but it will change in response to
changes in the factor prices. What we have just said for good X is equally true for
good Y. The relationship between average cost and factor prices will be discussed
later.
iii) In two goods model, it is assumed that one good is labour intensive and the other
capital intensive and this status does not change.
iv) Only goods move from one country to another, not factors.

C:o~iccptsand Dimc~lsions v) The countries have the same technologies to produce X and Y for their factor
endowments differ : one country is labour abundant and the other is capital
abundant.
The factors of production are fully employed : there is no unemployment of labour or
vi)
excess capacity,
2.4.4 Product Price Ratio and Factor Price Ratio
Under the assumption of constant returns to scale there is relationship between the product
price ratio, i,e., Px/Pyand the factor price ratio, i.e., w/r. This is discussed in Figure 2.2. As
you know, in a competitive market price is equal to average cost in the long run because
profit is competed away. Therefore, the product price ratio is equal to the average cost ratio,
i.e., the ratio between the average cost of X and the average cost of Y. In the figure two unit
isoquants are drawn and these are marked as X=l and Y=l. These isoquants represent one
unit of output for each of the two products. Every good will be produced at the mi~ii~nuln cost
by the profit maximising producers. AB is the isocost line whose slope is the factor price
ratio, w/r. The cost minimising condition is that the marginal rate of technical substitution,
measured by the slope of the isoquant, is equal to the factor price ratio, measurcd by the
isocost line. Thus, the input combinations at C and Dare the cost minimising input combina-
tions for producing one unit each of Y and X respectively. The cost of producing one unit of
output is given either by OB in terms of labour or by OA in terms of capital. Since AB is
tangent to both the isoquants, the cost of producing one unit, or the average cost is the
same for X and Y , Thus, with the factor price ratio given by the slope of AB, the average cost
ratio or the product price ratio is one, i.e., Pxffy = 1 and at this factor price ratio tlie capital
labour ratios of the two industries are represented by the slopes ofthe lines joining 0 with C
and D. It is quite obvious that Y is capital intensive and X is labour intensive. Another
important point fo note is that the average cost measured by OA or OB for producing X or Y
will remain the same no matter how many units of the two goods are produced. This is
because the average cost, under constant returns to scale, is independent of output and
responds only to changes in the factor price ratio.
Figure 2.2: Product Price Ratio and Factor Price Ratio
0 P M N B Labour
Let us now see how the average costs in the two industries producing X and Y change when
the wage rental ratio (w/r) rises. Common sense would suggest that since labour is inten-
sively used in X and since it is the wage rate (w) that rises relatively to the rental price of
capital (r), the average cost of X should rise relatively to the average cost of Y . In the Figure
2.2, the initial situation is one of equal average costs or product prices of tlie two industries
and this happens because the isocost line is a common tangent to both isoquants. But if w/r
rises, tlie cost minimisation points will not be on a colnmon tangent, rather tlie two industries
will mini~nisecost on different isocost lines. These two isocost lines are drawn as dotted lines
and Y-industry will mini~nisecost nl E, while X-industly will mini~iiisecost at F, l'liereforc, tlle
average cost ratio whicli is tlie same as tlie procjuci price ratio (P, IP, ) is now OM 1 ON
--
which is greater than one. This proves the proposition that as w/r rises, Px /Py will rise if X is Theories
labour intensive. The general relationship between the factor price ratio and the product price International Tra
ratio is that if the price of one factor rises relatively to that of the other factor, then the price
of the good intensive in that factor.wiII rise relatively to that of the other good. This relation-
ship is crucial to prove the neoclassical trade theorem which we take up next.
2.4.5 The Weckscher-Ohlin-Samuelson (HOS) Theorem
The HOS theorem states that a country which is relatively abundant in labour will have
comparative advantage in the labour intensive good and the relatively capita1 abundant
counhy will have colnparative advantage in the capital intensive good. Thus.it is the factor
abundance rather than technology which determines the pattern of trade. To prove the
theorem we use the relationship between w/r and Px/P which we have just established.
Assuming the X is labour intensive Figure 2.3 shows tiis relationship. The figure shows that
the foreign country is capital abundant and the home countty labour abundant by the factor
price definition of relative factor abundance, since (wlr), > (wlr),. As a result of this, a
comparison of autarky prices tells us: (Px/Py)h < (Px/Py), ,or the home country's relative
price of X is less than the foreign country's relative price of X in autarky. Therefore, the home
country (labour abundant) will export X (labour intensive) and the foreign country (capital
abundant) will export Y(capita1 intensive).
Figure 2.3: Pattern of Trade
As trade takes place the two countries' autarky prices will converge to the equilibrium world
price, just as in the Ricardian model, provided that there are no impediments to trade. The
Figure shows this equilibrium world price as (Px1P )* which is the commodity terms of trade
at whicli trade will take place in.equilibrium and (wh)* as the factorial terms of trade in
eguilibrium. In the neoclassical model free trade not only equalises the relative commodity
price in the two country but also equalises the relative wage rate.
2.4.6 Factor Price Equalisation Theorem
Free trade in the neoclassical model will not only equalise wlr in the two countries but will
also equalise the real factor prices. This is known as the factor price equalisation theorem.
A proof of the theorem is given by using Figure 2.2. In this diagram one can measure the real
wage rate and the ieal rental price of capitol. Let us suppoSe that the slope of AB is (w/r)*
which is the same in the two countries. But the slope of AB = (PCIPB) also measures the
marginal rate of technical substitution, or the slope of the isoquant marked as Y=I.Remember
that the marginal rate of technical substitution is the ratio of the marginal productivities of
factors, i.e., MPL / MPK, the ratio between the marginal productivity of labour and'the
marginal productivity of capital. Combine with this another implication of constant returns to
 scale, n a m c l that if factors are paid their marginal productivities, total output is exhausted.
These give us two equations:
1) MPL /MPK = PC/PB which implies that (PB) (MPL) = (PC) (MPK)
2) (OP) (MPL) + (PC) (MPK) =1
Substituting the first equation in the second equation we get : MPL = 1 / 0 9 . Similarly it can
be proved that MPK = 1/OA. The real reward ofa factor is nothing but its marginal produc-
tivity. Since 1/OB and 1/OA are respectively the real wage and the real rental price of capital
in Y, these must also be the real factor prices in X because under perfect competition real
factor prices cannot be different in the two industries. The X and Y isoquants drawn in
Figure 2.2 are the isoquants of both the home and the foreign countries as their technologies
are identical. Thus, with the slope of AB representing the equilibrium factorial terms of trade,
trade will equate the real factor prices in the two countries.
2.4.7 Samuelson-Stolper T h e o r e m
If the price of a good rises relatively to the price of the other good, what happens to the real
factor prices? In order to answer this question we go back to Figure 2.2. Remember that if the
isocost line is AB, P, /Pyis equal to one, the real wage rate is 1 /OB and the real rental price of
capital is I/OA. If the isocost lines are the dotted lines (EM or FN), then P, /Py is greater than
one, i.e., the price of X rises relatively to the price of Y. Now the real wage rate is ]/ON
measured in X and 1 /OM measured Y. In either case the real wage rate increases, because
both ON and OM are less than OB. You may check that the real rental price of capital declines
by looking at the ve~ticalintercepts of EM and FN. Also recall that X is labour intensive in
this case. This gives us the Samuelson-Stolper theorem which states that as the price of a
good rises relatively to the price of the other good, the real reward of the factor intensiveiy
used in the good whose price has risen (labour in this case ) will rise and the real reward of
the factor unintensively used (capital in this case) will fall.
2.4.8 Rybczynski Theorem
So far we have discussed the neoclassical theory only in terms of the factor price definition
of factor abundance. Let us now use the other detinition, namely the physical definition of
relative factor abundance. We start by again referring to Figure 2.2 where we recognise the
fact that the factor intensities, K, /Lxand Ky/Ly, depend entirely on the factor price ratio and
will change only if the factor price ratio changes. Also, the factor price ratio will change only
if the product price ratio changes and the Samuelson-Stolper theorem teaches us just this. It
then follows that if the product price ratio is constant, the factor intensities in the two
industries will stay constant. Now we ask ourselves the following question: Given the
product price ratio what will happen to the output in the two industries if the endowment
(supply) of a factor of production changes? Since the product price ratio is assumed to stay
constant, an increase in the supply of labour or capital will not change the factor intensities
in the two industries. Then our answer will come from the following box diagram (Figure 2.4).
The box shows that thc economy is endowed with OA amount of labour and AO, amount of
capital. The outputs produced in the two sectors are given by two isoquants marked as 'x
and 'y which are tangent to each other at P. Under constant returns to scale we may also
measure output along rays through the origin. In other words, the output of X can be
measured as OP and that of Y as 0,P. Note that at P the economy uses up all resources. In
fact, at any point in the box full employment of labour and capital takes place, but at P the use
of resources is optimal as the marginal rates of technical substitution, measured by the
slopes of the isoquants for X and Y are equal. Recall that this was also true in Figure 2.2
because the isoquants of the two products were tangent to the same isocost line or parallel
isocost lines. In other words, P is the point where the goods are being produced at the
minimum cost. Also note that as in Figure 2.2 X is the-labour intensive good and Y is the
capital intensive good. We cpn easily see this by comparing the slopes of OP and 0 , P which
tells us that X industry uses 'less cal;ital per unit of labour than Y industry. NOWlet the
supply o f labour increase by AB without any change in the supply of capital. Since this, as
argued, will not change the factor intensities, the new production point must be Q with PQ
being an extension of OP and 0 , P and 0,Q parallel lines. The new production point clearly
shows that the output of X rises from OP to OQ and that of Y. falls from 0 , P to 0,Q. Theories of '
International Trade
Generalking this result we state the Rybczynski theorem :If the supply of a factor rises and
the terms of trade remain constant, then the output of the good intensively using that factor
will rise and the output of the good intensively using the other factor whose supply has not
changed will fall.
Figure 2.4: ~elativeFactor Abundance
I.
0
Labour
i
I
Ii With the help of Rybczynski theorem we can now see the validity of the HOS theorem in
I
terms of physical definition of factor abundance. Let us suppose that the home country and
I -
the foreign country are identical in every respect, i.e., they have the same technology and
factor supplies. Then the production of goods in the two economies can be represented by
point P in Figure 2.4 for both countries as their isoquants are identical. Let us assume that the
consumers in the two countries have identical tastes and therefore identical demand func-
tions. As a result the,relative price of X in terms of Y will be identical in the two countries.
Now suppose the home country's labour endowment increases.by AB. The production point
for the home country will be Q and that for the foreign country will be P. In other words, the
home country becomes a labour abundant country and the foreign country a capital abun-
.
dant country. But now the two countries cannot have the same relative price of X in terms of
Y in their respective autarky equilibria. 'fiis is because the home country will produce more X
and less Y than the foreign country. With identical tastes of consumers in the two countries,
the relative price of X in terms of Y in the home country will be less than that in the foreign
country. Thus X will be relatively cheaper in the home country which produces too much of it
and Y relatively dearer as too little of it is produced. Therefore the HOS theorem is valid as
the home country which is labour abundant has comparative advantage in X which is labour
intensive and the capital abundant foreign country has comparative advantage in Y which is
capital intensive.
I
2.5 MODERN THEORIES OF TRADE
The contemporary theories of trade deviate from the assumptions of perfect competition and
constant returns to scale made both in the classical and the neoclassical models. In the
modern theories the market structure is either monopolistic or oligopolistic. In the former case
a large number of producers produce goods that are not identical but differentiated in quality
or design. In the latter case only a few producers serve the market with either identical
products or differentiated products. The products which are just differentiated horizontally
are similar in quality but different in design, like a red pen and a blue pen, white wine and red
wine or wooden furniture and steel furniture. Vertical product differentiation involves quality
differences as in small cars and large cars, lf the products are horizontally differentiated they
are produced by more or less the same technology. Vertical product differentiation would .
invariably mean that the technology varies with quality or type of the product.
Conccpta ant1 1)iancnsiuns The modem theories assume economy of scale in production. An example of economy of ............................................................................................................ Tl~eoriesof .
scale is shown in the following Table 2.2. International Trade
............................................................................................................
Table 2.2: Economy of Scale
4, What is Rybczynski theorem?

5. State whether following statements are True or False.

One may easily check that the technology described above is a departure from the constant
returns to scale we have been using so far. For example the output is doubled from 1 to 2 as
labour is less than doubled from 3 to 5. Suppose that there are two similar goods, A and B
being produced by the above technology, The economy has 10 units of labour. The consum-
ers will consume the two goods in 1:l proportion. Therefore the labour force will have to be
equally divided in the production of the two goods and 2 units each of A and B will be
produced and consumed in the economy. Now suppose there is another economy with the
same technology to produce A and B having 10 units of labour. Then it is quite easy to see
that one economy produces only A and the other produces only B and then trade with each
other then the consumers in each country will be able to consume 3.5 units each of A and B
and be better off than autarky. This is an example of trade taking place between two
countries having the same technology and factor endowments simply due to economy of
scale. But there is difference in the nature of trade. In the earlier models the products were
different and produced by different technologies and the trade was between two industries,
such as one country exporting cloth and importing wheat. This kind of trade is called inter-
industry trade. But in the contemporary models trade is intra-industry, i.e., in the same
industry located in two different countries. It is like one country exporting white wine and
-
importing red wine both goods requiring the same technology as in the above example. It
turns out that a very substantial part of world trade is intra-industry in nature which shows
the importance of modem theories in the contemporary world,
Check Your Progress B
I. Enumerate two assumptions of the Neoclassical theory.
...........................................................................................................
i) The pattern of trade in Ricardian theory depends entirely on the technological
differences between two trading countries.
ii) Under the assumption of constant returns to scale, there is no relationship
between the product price ratio and the factor price ratio.
iii) Average cost, under constant returns to scale is independent of output and
responds only to changes in the factor price ratio.
iv) According to Heckscher-Ohlin-Samuelson theorem, a country which is
relatively abundant in labour will have comparative advantage in the labour
intensive goods.
v) The contemporary theories of trade do not deviate from the assumptions of
perfect competition and constant returns to scale.
2.6 LET US SUM LTP
Trade theories explain the pattern of t r d e between two countries, the pattern of
specialisation znd the mutual benefit of the trade. There are various trade theories to
explain above phenomenon. Ricardian theory states that a country has comparative advan-
tage in the good in which its relative labour productivity is higher than its trading partner
and tends to export this good. The country terfds to import the good in which its trading
partner has con~parativeadvantage. Heckscher-Ohlin-Sarnuelson theorem emphasises
that a country which is relatively abundant in labour will have comparative advantage in
the labour intensive good and thk relatively capital abundant country will have comparative
advantage in the capital intensive good. This theory advocates that it is the factor abun-
dance rather than the technology which determines the pattern of trade. The modem
theories of trade assumes monopolistic or oligopolistic market structure and economy of
scale in production.

2.7 KEY WORDS

Absolute Advantage: The advantage enjoyed by a country because it can produce a
product at a lower cost than other countries.
2. Distinguish between product price ratio and factor price ratio.
Comparative Advantage: The theory that there may still be global efficiency gains from
trade if a country specialises in those products that it can produce more efficiently than
other products.

Economy of Scale: The lowering of cost per unit as output increases because of allocation of
fixed costs over more units produced.

3. What is factor price equalisation theorem? Terms of Trade: The quantity of imports that can be bought by a given quantity of a
country's exports.
" "~.~~~~~.~..~.~.~~....~~..~~~.~~~.~.~.~.........~..~~..~........~..,,.,....,...,,.~~.~..,.,,.,.,.,...,,,,
Concepts r ~ i Di~nensions
d
2.8 ANSWERS TO CHECK YOUR PROGRESS
UNIT 3 BALANCE OF PA
A 4 i) True; ii) False; iii) True; iv) True; v) False.
Structure
B 5 i) True; ii) False; iii) True; iv) True; v) False.
Objectives
Introduction
2.9. TERMINAL QUESTIONS Definition
Underlying Principles and Conceptual Framework
1. Critically examine Ricardian Theory of Trade. Balance of Payment Accounting
2. Describe The Heckscher-4hlin-Samuelson Theorem. Components of the Balance of Payments
3.5.1 The Current Account
3. "In the neoclassical model free trade not only equalises the relative commodity price 3.5.2 The Capital Account
in the two countries but also equalises the relative wage rate". Discuss. 3.5.3 The Other Account
4. Explain the Rybczynski Theory of trade with suitable diagram. Deficit and Surplus in Balance of Payments
Balance of Payment Disequilibrium
5. Explain the modem theory of trade.
Factors Affecting Balance of Payments
6. ~ i s t i n ~ u i sbetween
h 3.8.1 The Current Account
3.8.2 The Capital Account
9 Absolute advantage & comparative advantage
Methods of Correcting Disequilibrium
ii) Classical theory and Neo-classical theory. Let Us Sum Up
7. Write notes on: Key Words
Answers to Check Your Progress
9 Terms of Trade Termi: 11 Questions
ii) Free trade and gains from trade
iii) Factor price equalisation theorem.
3.0 OBJECTIVES

I
After studying this unit, you should be able to:
analyse the significance of balance of payments as 8 major variable of business environ-
ment

1 a describe the concept of balance of payments

a explain the accounting mechanism of balance of payment
e distiguish between the current account, the capital account and official reserves account
r describe the links among these accounts
e analyse the nature, causes and consequences of disequilibrium in balance of payment
a explain various measures of dealing with the disequilibrium in balance of payment.

3.1 INTRODUCTION
Following the emergence of global competition, managers have started taking interest in the
changing international scenario. To understand the dynamics of changing environment, they
I
-
require a thorough knowledge of the macro economic environment particularly the financial
I
and real linkages betwevn the domestic and global economies. How these linkages affect
business viability is of almost interest to them. These linkages are measured and relevant
II
statistics compiled and presented for analysis in balance of payments. In India, Reserve
Bank of India compiles the data and brings out quarterly statements regularly.

i Balance of payments statistics affect the exchange markets and are therefore, of concern to
I every one co~lcernedwith foreign exchange. Developments in foreign exchange markets
! may necessitate entailing changes in the relevant policies. The continuous deficits of BOP
: is an important indicator in credit rating of countries. Market may interpret the data as
evidence the country may have difficulties in servicing its debts. Therefore, corporate
managers must monitor balance of payments data on a regular basis, not only of their country
Concepts nnd Dimensions' but also of their trading partners. BOP situation is a key element in macroeconomic environ-
ment which is a major concern for the companies. In this Unit, you will learn the concept of
the balance of payment, the accounting procedures, the components and the disequilibrium
in the balance of payment. You will also be acquainted with the factors affecting the balance
of payment and themethods to correct the disequilibrium.
3.2 DEFINITION
Balance of payment is an accounting record of the transactions between the residents
of one country and the residents of the rest of the world over a given period of time.
Transactions in which domestic residents either purchase assets (goods and services) from
abroad or reduce foreign liabilities are considered uses (out flow) of funds because payments
abroad must be made. Similarly, trar~sactionsin which domestic residents either sell assets to
foreign residents or increase their liabilities to foreigners are sources (inflows) of funds
because payments from abroad are received. Thus, in a way, it resembles a company's
sources and u ~ rof, funds statement.
3.3 UNDERLYING PRINCIPLES AND CONCEPTUAL
FRAMEWORK
The balance of payment is part of a larger system of social accounts recording the economic
activity of an economy and its various sections. The social accounts relate to economic
transactions not only within the domestic economy but also between the domestic economy
and the rest ofthe world.
Balance of payment is concerned with economic transactions, Five basic types of economic
transactions may be distinguished. They are:
a) Purchases and sales of goods and services against financial items i.e. the
interchange of goods and services against claims and monetary gold;
b) , Barter, i.e. the interchange of goods and services against other goods and services;
c) The interchange of financial items against other financial items e.g. sale of securities
for money, or the repayment of commercial debts in money;
d) The provisions or acquisition of goods and services without requital, e.g. grants in
aid;
e) The provision or acquisition of financial items without requital, e.g. in payment o f
taxes or as a gift.
The social accounts have common rules of credit and debit for recording economic transac-
tions. Credit entries are made for the provision of goods and services o r of financial items,
whether they are sold, bartered, or hrnished without requital. Debit entries are made for
acquisition of goods and services or of financial items, whether these items are purchased,
obtained by barter, or acquired without requital, For the first three types oftransactions, the
rules immediately result in equal credit and debit entries. For the remaining types, a credit .
entry for goods and services or fjnancial items is matched by a debit entry for an unrequited
transfer, and vice versa.
\
As stated earlier, balance of payments is concerned with economic transactions between the
residents of the reporting country and the residents of the rest of the world. To acquire an
indepth understanding, it is necessary to clarify the concept of residents. This term is
certainly not identical with the term "citizen" though there is normally a substantial
overlap. As regards individuals, 'residents' means those individuals whose general centre
o f interest can be said to rest in the given economy. They consume goods and services,
participate in the productive process or otherwise carry out economic activity within the
territory of the country on other than a temporary basis. Members of diplomatic and
Balance of Payments
consular staffs and official missions,,~nembersof armed forces stationed abroad, and citizens
undergoing medical treatment or studying abroad are considered residents of their own
rather thari oftlle country where they are staying. The extent to which other citizens living
abroad are treated as residents (travellers) or foreigners (emigrants) depends upon a number
of factors such as permanence of their living and the extent to which they shift their general
"centre of interest". As regards non-individuals a set of conventions have been evolJed.
For example, governments and non profit bodies servicing resident individuals are residents
of the respective countries. For. enterprises, rules are somewhat complex particula~-lythose
concerning unit of corporate branches of foreign multinationals, According to IMF rules,
these are considered to be residents of countries where they operate, though they are not a
separate legal entity from the parent located abroad, l~lternationalorganizations like the UN,
tlie World Bank, the IMF are not co~lsidcredto be renidents of any national economy even
though their of.fices may be located within the territories of any number of countries.
-
3.4 BALANCE OF PAYMENT ACCOUNTING
The balance of payment is a standard double entry accounting record and as such subject to
all the rules of double entry book-keeping viz. for every transaction two entries must be
made. One credit (+) and one debit (-) and leaving aside errors and omissions, the total of
credits must exactly match the total of debits i.e. the balance of payments must always
balance.
Simple accounting rules followed in BOP are the following :
a) All transactions which lead to an immediate or prospective payment from the rest o f
tlie world to the country should be recorded as credit. Hence, all payments received
for export of goods and services as also loans received abroad or inward foreign
investment-whether direct or portfolio would be credit items,
b) Conversely, all transactio~~s which result in an actual or prospective payment from
I the country to the rest of the world should be recorded as debits.
c) A transaction which results in an increase in demand for foreign exchange is to be
I
recorded as debit entry while a transaction which results in an increase in the supply
of foreign exchange is a credit entry.
I
1
I
PAYMENTS
The balance of payments is a collection of accounts conve~ltionallygrouped into three main
categories with subdivisions in each.
Three main categories are:
a) The Current Account : Under this are included imports and exports of goods and
services and unilateral transfers, which reflect government and private gifts and
grants.
b) The Capitnl Account : Under this are grouped transactions leading to changes in
foreign financial assets and liabilities of the country.
c) The Reserve Account :In principle, this is not different from the capital account iti
as much as it relates to financial assets and liabilities. However, in this category,
only reserve assets are included. These are the assets which the central bank of the
country uses to settle the deficits and surpluses that arises in the other two
categories.
 gold movement account shows a debit. Gold imported (or exported) by other Balance of Payments
1i11dDinlensii~nb
('~~nccpts LIIGC~ Your Progress A
agencies form a part of the merchandise trade account.
1. What is Balance of Payment?
Tnble 3.1: Structure of Current Account in India's Balance of Payments Statement.
............................................................................................................I
! k Current Account Credits Debits Net
......................................................................................................... i

............................................................................................................
i I Merchandise
I
1I

I 1. Private
I
I 2. Government I
............................................................................................................ I
4 I II Non-monetary Gold Movements
I
2. Enumerate two basic types of economic transactions. I
!
1 111, lnvisiblw
I
I. Travel
..................................................................................................

2. Transportation
I 3. insurance
I
1 4. Investment Income
I
I 5. Government, not included elsewhere
I
............................................................................................. 1 6. Miscellaneous
I
3. What do you mean by residents? I 7. Transfer payments I
...................#..(.................................................,.............,................,,,..
(if Official
(ii) Private.
I
...........................................................................................................
............................................................................................................
I
Ill) Invisibles: Credits under 'invisibles' consist of services rendered by residents to
non residents, income earned by residents on their ownership of foreign financial
........................
..,.,,........(I...........,.............................,.........................I
I
assets (interest, dividends etc.), income earned from the use, by non residents, of
non-financial assets such as patents and copy rights owned by residents and the
4, Distinguish between Current Account and Capital Account of Balance of Payment. offsei entries to the cash and in kind gifts received by residents from non-resident.
Debits consist of same items with the roles of residents and non-residents reversed.
............................................................................................................ I
A few examples may be cited as follows.
.............................................................................................................. I Receipts in foreign exchange, reported by authorised dealers in foreign
, exchange, remitted to them by organisers of foreign tourist parties located
i abroad for meeting hotel and other local expenses of the tourists. This will be a
credit under "travel".
Freight charges paid to non resident airlines or shipping companies directly will
appear as debits under transportation.
3.5.1 The Current Account
Premiums on all kinds of insurance and re-insurance provided by Indian
Look at Table 1, where the structure of the current account in India's BOP statement has insurance companies to non-resident clients is a credit entry under "insurance",
been shown. Let us briefly discuss each of the above heads and subheads. Profits remitted by the foreign branch of an Indian company to the parent
Merchandise: Merchandise exports valued on F.O.B.. (Free on board) basis, on company represent a receipt of 'direct investment income', to be recorded as a
I)
private and government account are the credit entries data for these items. They arc credit entry under 'investment income', Interest paid by an Indian company on
calculated from the various documents exporters fill and submit to designated its borrowings abroad will appear as a debit.
authorities. Funds received from a foreign government for the maintenance of their embassy,.
ln~portsvalued at C.I.F. (Cost, Insurance and Freight) are the debit entries. The consulates etc, in India will constitute a credit entry under 'Government not
difference between the totals of credits and debits appears in the 'Net' column. This included elsewhere'.
is the balance on Merchandise Trade Account, a deficit, if negative and a surplus if Foreign exchange earnings of Indian consultancy firms for professional services
positive. rendered to non residents will be recorded as a credit entry under
'rniscellnneous'. Similarly, professional services provided to residents by non
11) Non-Monetary Gold,Movements: Gold is both a commodity and a financial asset. It
resident companies will appear as debit entry.
is treated as a financial assets when it is held by the monetary autlthority.,
"Monetisation" of gold refers to the transaction when the monetary authority Revenue contributions made by the Government of India to international
acquires gold, from residents and non residents to add to reserves. This get institutions or non resident entities abroad will be recorded as a debit entry
recorded as a debit entry in reserve account and the off setting credit elltry is made under 'official transfer'. Simply, cash remittances for family maintenance
in the non monetary gold account. Conversely, when the monetary authority received from Indian nationals working abroad will be a credit entry under
acquires gold demonetisation, resewe account shows a credit and the non monetary private transfers. Look at Table 3.2 whichgives you an idea about India's
balance of 'payments:
 Table 3.2: India's Balance of Payments
original maturity of more than one year are classified as long term flows. Long term foreign
investment measures all capital investments made between countries, including both direct
(In (15'8 Adillion)
foreign investment and purchases of securities with maturities exceeding one year. Short
term foreign investment measures flows of funds invested in securities with maturities of less
1998-99 1997-98 1996-97 1991-92
than one year. Because of the short maturity, investors of such securities will often maintain
Current Account their funds in a given country for only a short time, causing short term investment flows to
be quite volatile over time.
Ex ports, SO.
b. 34,298 35,680 34,133
18,266
Imports, c.i.,/: 47,544' 51,187 48,948 2 1,064 Table 3.3: The Capital Account in India's Balance of Payments
Tratle balance -13,246 - 15,507 -14,815
-2,798 B. Capital Account Credits Debits Net
I, Private
I. LongTeml
Investment income -3,544 -3,52 1 -3,307 -3,830
2. Short Tenn
Private transfers 10,280 1 1,830 12,367 ' 3.783
Oflicial transfers 307 379 II. Binking
41 0 460
Current Account Balance -4,038 -5,500 Ill. Otficial
-4,61 9 -1,178
Capital Account I. Loans
External assistance, net 820 907 1,109 3,037 2. A~nortisations
Of which: 3. Miscellaneous
Disbursements 2,726 2,885 3,056 4.366 'rot.;: Capital Account (I+II+III)
Amortisation - 1,906
Commercial borrowings, net 4.362 Private-capital Flows
Of which:
These flows consist of several type of transactions. Among them are: long term loans
Disbursements received by individuals and companies (other than banking institutions), investment by
Amodisation foreigners in the joint stock companies in India, repayment of long term loans by non-
Short term credit, net resident, obtained from residents, repatriation of Indian investments abroad, deposits in
I non-resident (external) rupee accounts and in foreign currency nsn-resident accounts.
NRI deposits, net Capital outflows (debit entries) comprise investments by residents in shares and other
Foreign investments financial assets abroad, repayment of foreign loans by residents, repatriation of foreign
investments in India, long term loans made to non-residents and so forth.
Rupee debt service
Other capital, net Short tenn capital flows on private account consists of short term borrowings and invest-
Total capital account ments.
Overrll ba lance 4,222 4,51 1 6,793
2,790 Banking
IMF, Net -393 -61 9 -975 786
Reserves and monetary gold -3,829 -3,893 Capital movements in banking sector covers changes in foreign assets and liabilities of
-5,8 18 -3,576
commefcial banks, whether privately owned or government owned and cooperative banks.
Source: Statistical Outline of India, 1999-2000. Assets consist of balances held by banks with their foreign branches or correspondent banks
abroad, and rupee assets representing loans granted by Indian banks to branches of foreign
The net balanke between the credit and debit entries under the heads merchandise, non- banks in India and correspondent banks. Liabilities consist of Indian banks' debit balances in
monetary gold movements taken together is the Current Account Balance. The net balance their foreign accounts and credit balances held by non resident banks and few other
is taken as deficit, if negative (debits exceed credits), a surplus, if positive (credits exceed institutions with banks in India. Any increase in assets (or decrease in liabilities) will be a
debits). debit entry while a decrease in assets (or increase in liability) a credit.

3 - 5 3 The capital Account
have learnt the Current Account of India's balance of payment. Let us now learn the
Capital Account.
The
account records the changes in the levels of international financial assets and
liabilities. The various classifications within the capital account are private, banking and
Distinction is also made between short term and long term capital flaws, loans with
Official Capital ~ 1 0 ~ Thiss : category covers transactions affecting foreign financial assets
and liabilities of the government of India and the Reserve Bank of India, excluding transac-
tions relating to official reserve assets. Government of India's purchase and repurchase from
the IMF are shown in a separate account. Loans received by the Government of India from
foreign governments and international institutions are treated as credit entries and amortisa-
tion or repayment of such loans as debit.
Look at Table 3.2 which shows India's balance of payments on Current Account and capital
Account in recent years.
 Conrcpts ant1 D i ~ n r ~ ~ s i u ~ ~ s
5.
The remaining accounts in India's BOP are set out in Table 3.4.
Table 3.4: IMF, SDR and Reserve Accounts
I
Balance of Payments
State whether following statements are Tru,e or False.
i) Balance of payments statistics affect the exchange markets.
ii) Freight charges paid to non resident airlines or shipping companies directly
will appear as credit under transportation.

Credits Debits Net I iii) Cash remittances for family maintenance received from Indian nationals
C IMFAccount working abroad will be a debit entry under private transfer.

( D SDR Account iv) Short term foreign investment measures flows of funds invested in securities
with maturities of less than one year.
E Reserves and Monetary Gold
v) Special drawing rights can be used to settle international payments between
The IMF account contains, as mentioned above, purchases (credits) and repurchases from
1
I
lnonetary authorities of member countries.
the IMF. SDRs (Special Drawing Rights) are a reserve asset created by the JMF and
allocated to member countries from time to time. Subject to IMF regulations, SDRs can be I
used to settle international payments between monetary authorities of member countries. I 3.6 DEFICIT AND SURPLUS IN BALANCE OF
.An allocation is a credit and the utilisation is a debit. The reserves and Monetary Gold
account increases (debits) and decreases (credits) in reserve assets. Reserve assets consist
I
I
PAYMENTS -
of RBI holdings of gold and foreign exchange (in the form of balances with foreign central You have learnt that BOP accounting is based on the principles of double entry book-
banks and investments in foreign governments securities) and Government's holdings of keeping, meaning thereby that for every credit entry, there is a debit entry. Thus, a BOP
SDRs. account always balances. The difference between aggregate debit and credits is called
balance. In case, debits exceed credit, balance is negative or deficit, when the credits
Check Your Progress B exceed dehits, the balance is positive or surplus. Obviously, the term, deficits or surplus
cannot thvi, refer to the entire BOP but sub set of accounts included in BOP.
! 1. What do you mean by monetisation of gold?
Where value of exports exceeds imports, the situation is referred as trade surplus or surplus
on trade account. Excess of imports over exports results in trade deficit on trade account.

Ilie transactions appearing in a balance of payments can be classified in two categories, viz
autonomous transactions and accommodating or financing transactions, Autonomous
transactions take place on their own, in response to their felt needs and are independent of
situation in the balance of payments. Accommodating or financing transactions refer to the
flows which take place in response to surplus or deficit in the balance of payments. For
2. What is invisibles? example, a country may incur or raise its liabilities or reduce its assets in order to pay for
the deficit. A deficit'in balance of payment exists when payments for autonomous or self
motivated transactions exceed receipts. In case, there is a deficit or surplus, there have to
be some co~npensatorytransactions to balance the imbalance.

Autonomous and financing transactions are also referred to as above the line a d below the
line respectively.

There are several concepts of 'balance' in balance of payments. These are:

3. What do you mean by Capital Account of BOP? I. Trade Balance: This is the balance on the merchandise trade account, i.e. jtem 1 in
the current account.
2. Balance on goods and services: This is the balance between the export and impom .
of goods and services. It is the net balance on item I and sub-items 1-6 of item I11
taken together.
3. Current Account balance: This is the net balance on the entire current account
items I+ll+IlI. When it is negative we have a current account deficit, when positive,
a current account surplus.
4. What is official capital flows? 4 Balance on current account and b n g term capital: This is also called basic balance.
I This is supposed to indicate the long term trends in BOP.

While changes in reserve assets are accurately measured, recording of other items is subject
to errors arising out of data inadequacies, discrepancies of valuation and timing, erroneous
reporting etc. These are reconciled through a fictitious head of account called 'Errors and
Omissions'.
 Balance of Payments
BALANCE OF PAYMENT DISEQUILIBRIUM
it, However, according to J-curve theory, a country's trade deficit worsens just after its
3.7
- currency depreciates bec,ac~seprice effects will dominate the effect on volume of inrports in
the short run. That is the higher costs of imports will more than offset the reduced volume of
A nation's balance of payment is said to be in equilibrium when it is neither drawing upon its imports. Thus, the J curve theory states that a decline in the va\ue of home currency should
international reserves to make excess payments nor accumulating such reserves as a result of be followed by a temporary worsening in the trade deficit before its longer term improve~nent.
its receipts. In other words, when a country is not able to pay for its imports of goods and
services from its export earnings, on accumulating reserves year after year, a disequilib-
rium in balance of payments sets in. Policy initiatives are needed to restore equilibrium.
3.8.2 The Capital Accannt

A disequilibrium in balance of payment may be short term or long term in nature. Short As with the current flows, government policies affect the capital account as well. A
term disequilibrium, arises largely on account of cyclical factors. A crop failure leading to country's government could, for example, impose a special tax on income account by local
a sudden fall in export earnings may create a shortfall and consequently a disequilibrium. investors who invested in foreign markets. A tax would discourage people from sending
their funds for investment in the foreign markets and could therefore, increase the country's
Long term or structural disequilibrium arises on account of long term strdctural changes in capital account. Capital flows are also influenced by capital controls of various types.
the economy. Fall in demand of export products due to technological changes may bring Interest rates also affect the capital flows. A hike in interest rates relative to other countries
about a decline in export proceeds. Decline in demand and prices for natural rubbcr on may affect capital inflows from abroad. Similarly, a reductiorl in domestic rates may induce
account of development of synthetics may be cited as an example. Such a situation call be peoplc to invest abroad. '
remedied only by diversificationof economy.
The anticipated exchange rate movements by investors in securities can affect the capital
- account. If a home currency is expected to strengthen, foreign investors may be willing to
- invest in the country's securities to benefit frorr~tlic currency rnovernent. Conversely, a
3.8 FACTORS AFFECTING BALANCE OF' PAYMENTS country's capital account balance is expectcd to decrease, if its home currency is expected to
weaken, other things being equal.
3.8.1 The Current Account
Wlien attempting to assess why a country's capital account changed and how it will change
A country's current account balance can significantly affect its economy, tl~erefore,it is in future, all factors must be considered simultaneously. A particular country may
important to identify the factors that influepce it. The most important factors are: experience a reduction in capital account even when its interest rates are attractive, if the
i) Inflation home currency is expected to depreciate.
ii) National Income --- ---
iii) Government Restructures -- METHODS OF COIUUDXING
3.9 - DISEQUILIBRIUM
iv) Exchange Rates.
When sucll a situation of disequilibriu~narises, the following measures are usually adopted.
Let us discuss them one by one. i) Use of past reserves
ii) Borrowings from IMF
Inflation: If a country's inflation rate increases relative to the countries with which it trades,
its current account would be expected to decrease. Due to higher prices at home, consumers iii) Monetary and fiscal policy measures
and corporations with in the country will most likely purchase more goods overseas (due to
iv) Exchange rate adjustments.
high local inflation), while tile country's exports to other countries will decline.
Let us learn them in detail.
National Income: If a country's national income rises by a higher percentage than tllose of
other countries, its current account is expected to decrease, other things being equal. As the
Use of Past reserves: A country may make use of past reserves ca finance the BOP deficit
real income level (adjusted for inflation) rises, so does consumption of goods. A percentage
provided such reserves are available. Such reserves consist of gold, foreign currencies and
of that increase in consumption will most likely reflect an increased demand for foreign
fund related assets i s . reserve position with the IMF and holdings of special drawing rights.
goods.
In recent years, increase in quotas and additional allocations of SDRs and expanded
private capital flows have contributed to an overall increase in national reserves of several
Government Restrictions: If a country's government imposes a tax on imported goods
countries.
(often referred to as a tariff) the prices of foreign goods to consumers effectively increases.
An increase in prices of imported goods relative to goods produced at home will discourage
Borrowing from IMF: Countries with disequilibrium in R.O.P. can make use of IMF
imports and is expected to increase the current account balance. In addition to tariffs, a
facilities. These are:
government may reduce its'imports by enforcing a quota, or a maximum limit on imports.
1. Stand bye loans
Exchange Rates: Each country's currency is valued in terms of other currencies through
2. Extended Fund Facilities (EFF)
the use of exchange rates, so that currencies can be exchanged to facilitate international
transactions, The values of most ci~rrenciescan fluctuate over time because of market and 3. Structure Adjust~nentFacilities (SAF)
government forces, If a.countryls current account balance decreases, other things being
4. Enlarged Structural Adjustment Facilities (ESAF)
equal, goods exported by the country will become more expensive to the importing coun-
, tries, if its currency strengthens, as a consequence, the demand for such goods will decline. 5. COIR :!~satory and Contingency Financing Facilities (CCFF)
For example, a refrigerator selling in the United State for $ 1OOiequire a payment of Rs. 3500, 6. S ~ ~ I L ' 'l'ransforrnation
III~C Facilities (STF).
if the dollar were worth Rs.351- Ks. 1 = $0.028). Yet, if the dollar were worth Rs.401- (Rs. 1 = $
0.025), it would take Rs,4000 to buy the refrigerator. wbich codd discourage Indians to buy
('ollrcpt~nnd I)imcl~sians
(a) Balance of trade Bnlan'ce of Pnyments
Monetary and fiscal policy measures: Monetary and fiscal policies are also llnportant todls
for influencing B.0.P. conditions. A change in money supply brought about either through (b) Current account balance
fiscal or monetary policies can bring about the required change in the level of total demand, (c) Balance of payment
which includes demand for imported goods and services.
(d) All of the above.
Exchange rate adjustments; Adjustments in exchange rate is an effective tool. A down- The sale of Indian jewellery to o US Departmental store shows up.
i i)
ward adjustment in exchange rate will make exports cheaper and imports dearer. In other
words, as a result of such a policy, exports will be encouraged and imports will be discour- (a) A credit in India's official reserves
aged and equilibrium will be restored.
(b) A credit on current account
All these methods, however, suffer from certain limitations. Hence, managing a state of (c) A credit in both (a) and (b).
disequilibrium in B.O.P. continues to be a major problem which every country faces. The
(d) None of the above.
major problem is that a policy initiative taken for the sake of achieving equilibrium in
B.O.P. comes into conflict with other, rather more endearing objectives, such as, economic iii) Capital movements in banking sector shows in
growth, employment and price stability. Reconciling such conflicts continues to worry
(a) Merchandise account
policy makers.
(b) Current account
Check Your Progress C
(c) Capital account
I. What is Balance of payment disequilibrium? (d) (a) and (c) above.
Suppose Air India buys 10 boeing 747 for $ 500 million in 1996, financed by
a 5 years loan from the US Export and Import Bank. There is one year grace
period on principal and interest payments. The net impact o f the sale in
India's balance of payments in 1996.
(a) A $ 500 million increase in lndiats trade deficit.
(b) A $ 50.0 million decrease in current account surplus

2. What is Current Account Balance? (c) All of the above

(d) None of the above.
v) Purchase of US Treasury bonds by Unit Trust of India shows up.
...........................(..............................................................................
(a) A credit on capital account
............................................................................................................ (b) A debit on capital account

............................................................................................................. (c) A debit on the current account

3. (d) A credit in official reserves account.

Enumerate three factors affecting Balance of Payments.
J
vi) Purchase of US dollar froln International Monetary Fund will be
..................................................I...,......,....,........,..,,...........,.......,.)(..,.

(a) A credit on official reserves account

............................................................................................... (b) A credit on capital account

................................................. .............................................................. (c) A debit on official reserves account.

(d) A credit in current account.
vii) Which o f the following items will not be included in balance o f payments
4. Enumerate three methods of correcting disequilibrium in Balance o f Payments. Capital Account.
(a) Purchase of shares by a US Pension Fund
(b) Purchases of US Treasury bonds by a US fund
(c) A fo;eign company liquidating its investments and repatriating the
proceeds
(d) Dividends received by an Indian company on its overseas investment.
viii) Which of the following will adversely affect the B.O.P.
5. Tick the right answer.
(a) A rise in interest rate
i) The accounting statement that summarises all the economic transactions
between the residents of the home country and the residents of all other (b) A rise in taxes
countries is called the
 (c) A rise in capital inflows
ol'tlle world to the country should be recorded as a credit entry. Conversely all transactions
(d) A rise in inflation rate. which result in an actual or prospective payment from the country to the rest of the world are
) In order to reduce its current account deficit, the Government of India must do debits.
which of the following'?
The Balance of payment is a collection of accounts conveniently grouped into three main
(a) Reduce the Llnion budget deficit These are: Current account, Capital account and the Reserves Account. Under
(b) Encourage foreign investments in lndia Current Account, imports and exports'of goods and services and unilateral transfers of funds
are included. In the Capital Account, capital transactions leading to changes in the assets
(c) Bring down the rate of interest and liabilities of the country are included. The Reserve Account is concerned with the
(d) Only a & b assets held by the central bank of the country which are used to settle the deficits and
surpluses that arises on the other two categories.
(e) a, b and c.
x) A stronger rupee will help India. Where the exports of merchandise exceeds its imports, the situation is referred to as trade
surplus or surplus on trade account, Excess of imports over exports results in trade deficit
(a) To reduce its current account deficit
or deficit on trade account. When exports and imports of services and transfers are added to
(b) To attract inore foreign investments in lndia the trade balance, result in balance is referred to as balance on current account. When
credits exceed debits, it is called a current account surplus. Conversely, an excess of debits
(c) Erode India's competitiveness and adversely affect its exports.
over credits results in a deficit on current account. The capital account records the changes
(d) None of the above. in the levels of international financial assets and liabilities. Therefore, the overall balance
6. State whether the following statements are True or False. is adjusted against movements in reserves assets.

i) Transactions arising from international business cause money flows from A nation's balance of payments accounts is said to be in disequilibrium when it is neither
one country to another. The balance of payments represents a measure of drawing upon its international reserves to make excess payments nor accum$lating such
international rnoney flows. reserves as a result of its receipts. It can be classified as a short term or cyclical disequilib-
The recording of transactions in B.O.P. statement is done by double entry rium and a long term or secular on structural disequilibrium. Cyclical disequilibrium arises
ii)
book-keeping. on account of cyclical factors and can be corrected by short term measures. Structural
disequilibri~lrnarises on account of long term structural changes and can be corrected only
iii) Unilateral transfer of funds by residents of one country to residents of another by initiating changes in econo~nicstructure such as diversification of economy.
are excluded in B.O.P. accounting.
US tourists who spend money in London will affect only US balance of Inflation, national income, government restrictions and exchange rates affect the balance of
iv)
payments and not UlC's. payments on current account. lf a country's inflation rate increases relative to the countries
with which it trades, the current account will be adversly affected. If the national income of
v) If a country's inflation rate increases relative to the countries with which it a country rises relative to its trading partners, other things being equal, its current accouiit
trades, its current account would be expected to increase,.other things being will decrease. Si~nilarlyimport restrictions will reduce the demand for i~nportsand the
equal. current account balance will increase. A rise in the value of donlestic currency in term of
vi) If a country's national income increases by a higher percentage than those of other currencies, will increase the export prices, adversely affect the exports and
other countries, its current account is expected to decrease, other things being consequenty a decline in current account balance, Reserve situation arises in case of
equal. depreciation of domestic currency. A disequilibrium in balance of payments can be cor-
rected either by making use of national reserves, making use of IMF facilities, use of
vii) A strong local currency is expected to reduce the currency account balance if appropriate monetory and fiscal policies and exchange rate mechanism.
the traded goods are price elastic.
viii) If a country's home currency is expected to strengthen, foreign investous
may become reluctant to invest in country's securities. 3.11 KEY WORDS
irc) A surplus in home country's budget can adversely affect its current account
balance. Balance of Payments - Statement of inflow and outflow payments for a particular
country.
x) A rise in home count~y'sinterest rates adversely affect the capital inflows,
Balance of Trade-Difference between the value ofmerchandise exports and imports.
3.10 LET US SUM UP Balance on goods and services -Balance on trade, plus the net amount of payment of
1
interest and dividends to foreign investors and from investment, as well as receipts and
Following emergence of global competition and consequently increased flows of goods, payments resulting from international tourism and other transactions.
services and capital, an understanding of balance of payment statistics is very essential for
understanding changes in international macro environment. , Current Account - Broad measure of a country's international trade in goods and
1
services.
I
Balance of payment is an accounting record of the transactions between the residents of one
I
country and the residents of the rest of world over a given period of time. It is a standard Capital Account - Account reflecting changes in country in ownership of long term and
double entry accounting recordand as such subject to all the rules of double entry book- short term financial assets.
48 keeping. All transactions which lead to an immediate or prospective payment from the rest
Concepts and I ) i m c ~ ~ s i o r ~ s
I n t e r ~ ~ a t i oMonetary
n~l Fund ( I MF) - Agency established in 1944 to pronlotc and facilitate -- --

intemationa1 trade and financing. UNIT 4 INSTRUMENTS OF T

d Curve effect - Theory that says a country's trade !:lcl'icit will initially worsen nficr its
currency depreciates because higher prices on Soreiga i ~ n ~ ~ owill
r t s more than ol'fset ~h,.:
reduced volume of imports in the shorL run.
Structure
Tariff- Tax imposed by a government on illipoiteil goods.
Objectives
Official reserves -Holdiilgs of gold and foreign currencies liy official monetary inshiiu- Introduction
A Partial Equilibrium Theory of Trade
tions.
Non-Tariff Barriers to Trade
-
Special Drawings Rights (SDR) A new fonn of internatio~~al reserve assets, created by Quota versus Tariff
the IMF in 1967, whose value is based on a portfolio of widely used currencies. Exchange Control
Balance of Payments Adjustments
Flexible Exchange Rates
-- Fixed Exchange Rates
3.12 ANSWERS TO-CHECK YOUR PROGRESS
- - Let Us Sum Up
B 5 i) True; ii) False; iii) False; iv) True; v) True. Key Words
Answers to Check Your Progress
C 5 i) (c) ii) (b) iii) (c) iv) (a) v) (b) vi) (a) vii) (d) viii) (d) ix) (d) x) (c) Terminal Questions

6 i) False ii) True iii) False iv) False v) False vi) True vii) False viii)
False ix) False x) False
4.0 OBJECTIVES
3.13 TERMINAL QUESTIONS After studying this unit, you should be able to:
-
I. What do you mean by the Balance of Paytnent Accounting? Describe various explain the partial equilibrium theory of trade
components of the Current Account. describe various non-tariff barriers to trade
2. Distinguish between the current account and the capital account. Describe the e discuss the impact of quota and tariff
components of the capital account.
e explain the exchange control mechanism
3. What is balance of payment? Explain the factors affecting the balance ofpayments.
e describe the method o f balance of payment adjustments
4. How disequilibrium occurs in the balance ofpayment? Describe the methods o f
correcting the disequilibriuin. @ explain the flexible and fixed exchange rates system

5. Select a country and unde~talcean analysis of that country's balance of payments

for 5 to 7 years. The analysis must include exan~inations(presentation of
statistical data with discussion) of the trade balance, current account balance, basic
balance and over all balance.
6. Discuss the trend in India's balance of payments since 1991. How can you explain
the trend ?
4.1 INTRODUCTION
You have learnt the theories related to patterns of trade among countries in Unit 2. YOU
have also seen that for all countries free trade is better than autarky. Even though fiee trade
is better than a complete absence of trade, is free trade better than restricted trade, i.e.,
trade restricted by import tariff, import quotas or exchange controls? It turns out that tlie
answer depends mainly on whether the country is large or small. The countries that tend to
restrict trade by charging an irnpol-t tariff (a tax on imported goods) are said to follow a
protectionist trade policy. A tariff is a price based policy to restrict trade because it changes
the price of import paid by the importer. But there are other ways to restrict trade and some
of these are non-price based policies. For instance an import quota will rest~ictthe quantity
of import. These non-price based policies are known as non-tariff barriers to trade. In this
unit, you will learn the partial equilibrium theory of trade and various non-tariff barriers to
restrict trade. You will be further acquainted with the impact of quota and tariff, exchange
control, balance of payment adjustments and the exchange rates system.

4.2 A PARTIAL EQUILIBRZUM THEORY OF T E

Even though the markets are generally inter-related sometimes it is useful to focus on one
market provided its links with other markets are not very strong. Then apartial equilibrium
theory of trade is just an extension of what you have learnt in microeconomics, Suppose.
 Concepts and Dimensions that there are a large number of producers and consumers of a product competing in a
Figure 4.1: Equilibrium Price Instruments of Trade Policy ,
market where the price is determined by the interaction between the suppliers and the
consumers. Look at Figure 4.1 where the equilibrium price in the market is marked as Pd
Price
At the equilibrium, the quantities demanded and supplied are equal to OQ with the demand
curve and the supply curve being DDr and SS' respectively. If the country is in autarky, then
the consumers' welfare in equilibrium may be represented by the triangle abP, which is
known as consumer surplus.

Box 1: Consumer surplus

Let DD' be the demand curve. If the market

price is Oc, then OQ is bought. For any
quantity less than OQ, say OQ, , the con-
sumer will pay dQ, which is more than the
the market price, eQ, = Oc. Therefore the
difference between the price the consumer is
willing to pay and the actual price paid, i.e.,
de is the consumer surplus fiom purchasing D'
the Q,th unit. Adding all these surpluses
from 0 to the Qth unit we get the total o Q, Q Quantity
consumer surplus, namely the triangle abc.

You can see in the figure that for all quantities less than OQ the consumer is willing to pay
more than P, but actually pays just P,. When the last unit up to OQ is purchased the
D'
difference between the price offered by the consumer and the price actually paid is just I I
zero. If we add these differences up to OQ we end up with #e triangle abPdwhich is the I I I
I I
I
I
I
consumer surplus. I I
B' Quantity
0 A A' Q
Let us now assume that the world price of this good is pwwhich is less than pd,~t this
I stage we make an important assumption. We suppose that the country is a small country.
I In trade theory a small country does not necessarily mean that the country is small in size, competingfirms raise price to \(I+t) and expand output from OA to OA'. This is
1 import substitution The consumen will buy less as they are paying a higher price.
A small country is simply a small operator in the world market and therefore does not have quantity demmded falls from OB to OB' and as a TeStIlt the impod falls from AB A'Br-
a monopoly power and takes the world market price as given. At Pwthe country's producers the area 'w
L~~us work out the implications of all this. The producers' gain is measured
will produce OA but the consumers will demand OB and the difference (AB) will be
imported. Trade will increase consumer surplus to a bigger triangle, namely acPw.The d f, the government's ~ l s t o m revenue
s by the rectangle g h k j and the loss of consumer
sumlus by the area fghckjdPw.The consumers' loss is more than the producers' gain and
anount of hcrease in consumers' surplus is given by the area P, b c pw YOU now the govemmentysgain put together. It is easy to see that the net loss to the society (jae*>
recognise that OA is the output produced by the domestic import competing firms who producers' gain plus government's gain minus the loss of consumen' s u ~ l u )s is measured
were earlier producing OQ before trade. Therefore trade has hurt the impolt competing
by two triangular areas, namely gjd and hkc. The net loss to the socieb' is also known as
industry where some firms may have stopped production. But the consumers have gained.
deadweight loss.
It can be shown that the producers' loss is less than the consumers' gain and therefore
trade raises net social welfare. But how can we say this? Those who are familiar with the Box 2: Producer Surplus
concept of producer surplus will immediately recognise that area Pdbd pw is the loss of
producers (Those who are not are referred to Box 2). Remember that the supply curve is Let SS' be the supply curve which is
simply the marginal cost curve under perfect competition and therefore the area under the
simply the marginal cost curve show-
supply curve is the total cost. Total revenue is price multiplied the quantity supplied and is ing additions to cost for producing one
measured by a rectangle. The producers' surplus is simply profit which is the difference more unit of output. The area under b
I
between total revenue and total cost, Before trade when OQ was produced the profit was the supply curve for any given output
the triangle e b P, which is reduced to the triangle e d Pw.The loss of profit is the area pwd gives total cost of producing that out- a
b Pdand this is certainly less than the gain in consumers' surplus given by the area P, b c
put. For example, when the output Pro-
Pw.The net gain fiom trade is measured by the triangle bcd which shows that the society is
duced is OQ, the total cost is the area
better off with trade than with autarky.
OQcS. Since an output of OQ is sold at
a price of Oa, the total revenue is given
0 Q
What happens if the world price is higher than the domestic autarky price? From the figure
by the rectangle OacQ. The difference
we can easily find that the country will export the good if the world price is Pw*.
betwaen total revenue and total cost works out to be the triangular area
'
which is the producer surplus Or profit. AS price rises to Ob and
The Figure we have drawn above can be exploited a bit more to show that for a small country
supply to oQ, the producer surplus rises by the area abdc~
free trade is the best commercial policy. Let the government impose an ad valorem tariff on
import at the rate oft. This tariff is on the value of imported goods and therefore the import- what happens if do not assume that the country is a Small country with no power
ers Pay Pw(l+t) instead ofPw for every unit of the product that is imported. If import costs ence the world price? mena tariffmay not be a bad idea. The reason is that atariffleads a
I
Pw(l+t) the domestic producers will charge no less. Therefore the import 53
52
C
P A
 fall in the country's denland for import. ?his significantly affects the world demand for the
good under coasideration, as the country is a major importer. This leads to a fall in the world
market price Pw.Now there are two conflicting forces. First, [here is a deadweight loss as we
have just seen. But since Pw itself declines, the consumers are better off paying a lower price
and the import competing firms are worse off because they have to lower their price. The
import demand will surely rise but it will not reach the original level, i.e., AB though it will be
greater than A'B'. Thus we cannot say whether the government will collect more customs
revenue or not. But the fact still remains that the second set of effects may have a positive
impact on social welfare which will partly offset the deadweight loss. The tariff rate which
bala~lcesthe deadweight loss with the gains due to a fall in Pw is known as the optimum tariff.
In other words, for a large country havingmonopoly power in the world market will not find
free trade to be the best policy but will find an optimum tariffrate which maximises its social
welfare.
The partial equilibrium theory oftrade applied to one good is not very meaningful because it
ignores the interaction between goods. In any case it cannot tell us anything about the
pattern oftrade between two countries. This is why we have discussed only the general
equilibrium models of trade in unit 2. But the model discussed abbve is not entirely value-
less. If we assume that all imports of a country can be aggregated into one composite good,
then we would measure the quantity indcx of this aggregate import on the horizontal axis
and its price index on the vertical axis and use the figure 2 , I to discuss the ei'fects of a tariff
in the same way as we have done in the case of one good.
- --
4.3 NON-TARIFF BARRIERS TO TRADE
As mentioned earlier tariff is not the only instrument to restrict trade and give protection to
the domestic import competing industry. The non-tariff instruments are numerous. Recently,
United States of America has decided to bar1 import of carpets fro~nIndia on the ground that
child labour is used in the Indian carpet industry to which the human rights activists have
serious objections. In the past on many occasions consignments have been returned by
USA on the ground that the goods pose health l1azal.d~to the citizens of the countly. Thus,
human rights, damage to environment, health considerations, injury to domestic industries
etc, are the excuses offered by the importing country to restrict or prohibit imports. Sucli
restrictions are cailed non-tariff barriers.
Various non-tariff barriers are imposed by the governnlent to discriminate against imports
or in favour of exports. Let us discuss briefly major kinds of non-tariff barriers and their
implications for international trade.
Customs classification and valuation: The duty imposed on a particular import good
depends on how it is classified in the tariff schedule and how it is valued by the custo~ns
authorities. This ambiguity provides customs authorities opportunity for arbitrary classifi-
cation and detennining value of imported goods. Customs authorities usually charge higher
duties which may act as a deterrent to trade.
Subsidies: Subsidies are provided by the government to don~esticproducers or exporters to
stimulate the expansion of such industries. For example tax exemptions, cash disburse-
ments, preferential exchange rates, government contracts with special privileges or some
other favourable treatment. Subsidies help companies to bc cost competitive. Government
provides various types of export assistance to exporters to make the export business more
profitable and attractive.
Local content and Foreign investment performance requirement: Local content regula-
tions are imposed on certain industries to promote import substitution and encourage the
domestic producers, According to these regulatio~lscertain percentage of inputs used in the
n~anufactlrreof goods are required to be procured from the domestic suppliers. In the same
- way, roreign investors are required to export a certain proportion of its outl7ut fro111tile
domestic counlry under the foreign investment performance requirement.
Tecllnical Standards and I-flealth Reguiations: Many regulatio~~s are imposed on imports with of Trade Policy
Irrstrt~n~ents
I-espectto safety, health, marking, labelling, packaging and technical standards, quality
standards and natural environment. Such regulatio~lspose hardships and create barriers on
foreign produced goods. .As a result, some products may freely enter in one country and may
be banned in anotller cuunby. For example Japanese government requires that some import
goods be tested in Japan even when they have already been tested in the domestic country.
USA prohibits imports of many types of agricultural products on these grounds.
Government proeuremcnl: According to this policy, government purchases give preference
to domestically produced goods. For example, buy American regulatior~of USA govelnment
provide US protl~~cersPrice advantage on Deft:ncc, departtpent contracts.
Restl-ictions on Scrmvices:Noh-tariff barriers are imposed to curtail trade in services. For
example restrictions are imposed on transportation, banking, insurance, advertising,
accounting, law, engineering, construction, franchising, tourism, education, health, busi-
ness services, etc. on various grounds.
Besides above restrictions, there may be voluntarily export restraint, anti-dumping restric-
tions, specific permission requirements, administrative delays and procedures, etc.
4.4 QUOTA VERSUS TARIFF -
An import quota is the simplest instrument for implementing a policy of norr-tariff barriers,
Quota is not allowed under the provisions of the General Agreement on Tariffs and Trade
(GATT). But a country may justify imposition of quota by giving the excuses mentioned
above or even ban import. Such decisions may be challenged by the exporting country in
the World Trade Organisation. We want to compare the effects of a quota with that of an
equivalent tariff. For this purpose we shall use a diagram similar to Figure 4.1 except that
now we assume that the countries having trade are large countries and are capable of
intluencing the world market pl-ices. It is quite easy to dcrive from Figure 4.1 the importing
country's demand schedule for imports. This will be simply the country's excess demand
curve. In Figure 4.1 at price eqi~alto P, there is no excess demand and therefore the
demand for import is zero. At any price less than P, the market demand is greater than the
s~~pply and this excess dcmand is the demand for import. Since the country is assumed to
be an importer we do not look at any price higher than P,. In Figure 4.2 we have drawn this
excess demand for import dernand schedule marked as D. At the home country's autarky
equilibrium price P, home import is zero and import is positive at any price less than P,.
As price of import falls the home demand for import rises. On the other hand S q s the
foreign country's supply curve which shows that highcr the price higher is the quantity
offered for export by the foreign country. The world trade equilibrium is at the pdce P, at
ulbich the home country will import M, quantities of the good and the foreign country will
csport the same quantities in free trade.
Now let us suppose that the home country imposes a specific tariff at the rate oft. A specific
tariff is levied on the quantity of import, as distinguished from an advalorem tariff which is
.
on value of import.The effects of the two are not very different. As aresult of the tariff the
honle importers will have to pay a higher price for the import, say P, and demand less quantity
of import, say M,. But then the price in the world market will fall from P, to P," which is the
terms of trade effect of the tariff, Since both countries are large, a fall in the home demand for
import from M, to MI leads to a fall in the price of import. If the home country is small coun-
try, then S* would be a horizontal line starting at P, and there would be no terns of trade
-
effect of the tariff, The difference between the home price and the foreign price, i.e., P, P,* is
the tariff collected from every unit imported. One can see that this tariff is partly paid by the
foreign sl~ppliersbecause they reduce their price from P, to P,* and the rest is paid by the
domestic importers. Since D is the excess demand curve, the area marked numbers as 12345 is
the net loss of cansumers surplus after taking account of the gain in producer surplus
accruing to the domestic import competing producers who get a higher price for their product
as a result of the tariff. The revenue collected from tariff is 2367, Thus the net effect on social
Concepts and Dimensions welfare is the reclallgle 4576 minus the triangle I25 which may be positive or negative. The
tariff rate which balances these two influences on welfare is the optimum tariff.
Figure 4.2: Quota and Tariff
Price
1 I
0
I
Mt
M, . Quantity
What would be the effect of a quota which is equivalent to tariff in the sense that both lead
to B e same reduction of import? The quota, therefore, will have to be fued at M, , with the
stipulation imports in excess of M, are banned. The government will issue import licences
for permissible imports. The effect of this on the domestic price will be the same as tariffs
effect. The domestic price will rise fmm P, to Pt and the foreign price will fall from P, to
P,*, latter being the terms of trade effect of the quota. But the difference between the
domestic price the foreign price now goes to the holders of the import licence who buy at
.
Pt* fmm the world market and sell in the domestic market at P, The rectangle '2367 which
was the tariff revenue earlier is the rent going to the holders of the import licences. We are
calling it rent because rent is the reward earned by a fixed factor of production, in this case
the import licences. The government however may get it back if the imported licences are
not given h e but auctioned to the highest bidders. In lndia we never had a system of
auctioning import licences. Therefore, the import licensing policy which we had prior to
1991 used to yield rent to the licence holders.
4.5 EXCHANGE CONTROL
h lndia before trade liberalisation in 1991 import licensing was combined with exchange
control. In other words, only the holders of the import licences were given permission to
purchase foreign currencies fmm banks. Therefore, exchange contml or the control on the
issue of foreign currencies was simply a part ofthe import licensing system. This is what
has made Rupee a non-convertible currency. The current policy is that Rupee is convert
ible on all current account transactions which include trade in goods, travel and tourism.
F Qthese
~ transactions no import licences are required, Many developing countries use
&change control as a means to restrict trade. The distortions that come with exchange
~ h f t 0 1policy are in the form of black markets for foreign currencies where the foreign
1 ment is divided into three parts :the current account, the capital account and the official
currencies are sold at rates much higher than the official rates. Thus, the rent goes to the Instruments of Trade Policy
sellers of foreign currencies in the black markets.
Check Your Progress A
1. What is consumer surplus?
............................................................................................................
............................................................................................................
............................................................................................................
2. What do you mean by Producer surplus?
............................................................................................................
............................................................................................................
............................................................................................................
............................................................................................................
3. What is deadweight loss?
4. State whether following statements are True or False.
i) The partial equilibrium theory of trade applied to one good is very meaningful
because it ignores the interaction between goods.
ii) The large country having monopoly power in h e world market will not find
free trade to be the best policy.
A tariff leads to a fall in the country's demand for import.
iii)
iv) The producer's surplus is the difference between total revenue and average
cost.
Quota is allowed under the provisions of the GATT.
v)
4.6 BALANCE OF PAYMENTS ADJUSTMENTS
When we discuss import licensing policy or exchange control we assume that the objective
of the government is to restrict import so that the domestic import competing industries are
given encouragementto expind and replace imported goods. Very often, however, the
government's objective is not so much to promote import substitution (because the country
may not even produce the goods that are imported) but to reduce the import bill. This takes
us to the concept of the balance of payment. Every country is like a company v i s - h i s the
rest of the world and it has to settle accounts with the other countries. The statement of a
country's financial transactions with the rest of the world is called the balance of payment
statement. You may look at any issue of Economic Survey for India's balance of payment
statement. You have also learnt the balance ofpayment in Unit 3. To recapitulate, the state-
account, The entries in the current account show values of exports and imports during the
 financial year. The difference between the value of export and the value of imports (in rupees
or dollars ) is the balance on trade account. So we have a trade surplus or a trade deficit
depending on whether the balance on trade account is positive or negative. There are other
entries in the current account, like travel or tourism which are called invisibles. The invisibles
are also like exports and imports of goods. When a foreign traveller comes to India and
purchases hotel services, it is our invisible export. When our tourists go abroad and do the
same thing, it is our invisible import. The balance on invisible trade (export minus import)
plus the balance on trade account (trade deficit or surplus) is called thq current account
balance. Then we come to the capital account of the balance of payment statement. The
transactions here are in the nature of capital import or export. If the government of India or an
Indian company makes an investment abroad, say by purchasing a financial asset, it is capital
export. If the foreigner invests in India it is capital import. The foreign investment may be
either direct investment or portfolio investment. If a foreign company comes to India and sets
up a factory or a shop to do business directly with the Indian people, it is direct investment.
On the other hand, if the foreigner simply invests in shares and bonds floated by Indian
companies, it is portfolio investment. There is an element of asymmetry between current
account and capital account. In current account imports are items for which we make pay-
ments to the foreigners and exports are our receipts from the foreigners. In the capital
account import of capital is areceipt item and the export of capital is a payment item. There-
fore the balance on capital account is total capital import minus total capital export and a
positive balance is a surplus and a negative balance is a deficit.
The total balance, i.e.,the balance on current account plus the balance on capital account is
called the balance of payment which may show an overall deficit or surplus. A country may
have a deficit in the current account but a surplus in the capital account and an overall deficit
in the balance of payment.This was precisely the position in India's balance of payment in
the last financial year. A balance of payment deficit simply means that certain payments are
due to the foreigners and a surplus means that the foreigners are indebted to us in respect of
certain payments. Since a deficit or a surplus needs adjustment, we have an official account
showing how this adjustment is made. A BOP deficit may be adjusted by the Reserve Bank of
India through sale of foreign currencies released from the foreign exchange reserves, or by
borrowing from the International Monetaty fund or by foreign aid. A surplus may be
adjusted by increasing the foreign exchange reserves. When all these official transactions
take place, the grand balance, i.e., balance on current account plus balance on capital
account plus balance on official account, becomes zero and this has to happen by the law of
accounting.
4.7 FLEXIBLE EXCHANGE RATES
-
There is a close relationship between the balance of payment and the exchange rates of a
currency. One should notice that a deficit is simply an excess demand for foreign currencies.
Let us suppose that our imports are worth $5000 million and export earnings are $4500 which
will not be enough to pay for our imports and there is a trade deficit of $500 million which is
the excess of dollar demanded by our importers over dollar supplied by our exporters. The
Central bank, which in our case is the Reserve Bank of India, has two options. One is to
supply $500 million from foreign exchange reserves to meet the excess demand and this will
show in the official account of the balance of payment. The second option is not to supply
any dollars at all in which case the excess demand for dollar will exert pressure in the foreign
exchange market on the exchange value of Indian Rupee. If the Rupee rate was Rs. 30 per $
before the deficit appeared, it may change to Rs. 35 per $. Figure 4.3 shows this with the
rupee-dollar exchange rate being fixed as Rs. 30 at which the demand for dollar is $5000
million and the supply of dollar is $4500 million, leaving an unadjusted deficit of $500 million.
At this stage you should understand why the demand curve is downward sloping and the
supply curve upward sloping. We demand dollars to import goods and services from the
United States. If dollar becomes cheaper (as the rate changes from Rs. 35 to Rs. 30 per dollar)
the Indian importers find American goods cheaper in Rupee terms and therefore demand
more imports from USA. Agood whose price is $10 used to cost Rs.350. But now it will cost'
Rs. 300. We assume that the increase in Indian demand for U.S. goods does not affect the
prices (measured in $) in the U.S. Since the importers would purchase more quantities but pay
the same dollar prices, the demand for dollar increases. This is the reason why the demind
downward sloping. The si~pplycurve is upward sloping because more expensive the dollar is Instruments o f Trade Policy
(as the rate changes from Rs. 30 to Rs. 35 per dollar) higher is the income in rupees from
exports to the U.S. per unit of a good exported and greater is the quantity exported. Again,
assuming the U.S prices are fixed, the amount of dollar supplied by the Indian exporters is
more.
Now the question is how the deficit of $500 million at the exchange rate,ofRs. 30 per $ is
adjusted. Under the fixed exchange rate system RBI sells $500 to keep the rate fixed at
Rs. 30 and this shows up in the official account of the balance of payment statement. If
nothing is done by RBI the rate will automatically change to Rs. 35 per $. This adjusts the
deficit in the following way: With $ being more expensive our import demand falls from
$5000 million to $4800 million. The exporters find it profitable to export more to earn a
greater export revenue which increases from $4500 million to $4800 million. This is the
adjustment under the flexible exchange. rate system and RBI simply does not intervene in
the foreign exchange markets. If the exchange rates are freely flexible, there cannot be a
deficit of a surplus in the balance of payment because such imbalances are automatically
adjusted in the foreign exchange markets. The system we have at the moment in India can
be regarded as a flexible exchange rate system. The Reserve Bank does not normally
intervene in the market unless there are special reasons to do so.
Figure 4.3: Bnlnnce of Payment and Exchange Rntos
Rs. 35
Rs. 30
-1
Rupee is said to depreciate against foreign currencies in the case of a deficit in the balance of
payment and appreciate in the case of a surplus. But the story of flexible exchange rates does
not end here. Under this system the exchange rates fluctuate in response to changes in the
demand and supply conditions in the foreign markets where the demand and supply curves
keep shifting. When the exchange rates change, i.e., appreciate or depreciate, the economy
has to adjust to the new rates in several ways. Let us suppose that rupee depreciates against
$ and the rate changes from Rs. 30 to Rs. 35 per $. Does this eliminate the deficit? In terms of
the figure drawn above it does. But the figure shows the demand and supply curves of a
particular time period. Can the deticit come back in the next period? The answer is yes. Due to
the depreciation of Rupee, Dollar is now more expensive causing a decrease in our imports.
Since imports supplement domestic supply of goods and services, a decrease in imports .
leads to shortage and an increase in the general price level, Quite a lot of these imports are
used in the export industries as inputs and a shortage of these imported inputs raises the
prices of the exportables. So you see that currency depreciation may very well raise the
inflation rate and erode our comparative advantage. With the prices of Indian exports rising,
our exports will suffer in the world market and we will be able to export less goods and
services. With the fall in exports the deficit may come back which would then require further

depreciation. I n Uact there is a theory according to which the rate at which Rupee has to
depreciate is equal to the rate of inflation. But there may be inflation in the rest of the world
also which tends to improve our comparative advantage. Thus the theory, ltnown as the
purchasing power parity theory, predicts that under the flexible exchange rate system the
rate at which Rupee will depreciate will be equal to the difference between the Indian
inflation rate and tile inflation rate in the rest of the world.
The adjustment of the price level is one aspect of the adjustment process. Another aspect is
the effect of the depreciation on terms of trade. It is quite obvious that depreciation makes
our imports more expensive in rupee terms. The prices of exportables are rupee prices
because these are goods produced at home whereas the prices of importables are measured
in the currencies of ihe countries from which these goods are imported. After Rupee
depreciates the rupee prices of importablcs rise relative to the rupee prices of
exportables causing a deterioration in the commodity terms of trade.
So far we have only looked at transactions in the current account of the balance of pay-
ments. Let us now turn to the capital account and see what implications a currency depre-
ciation has for capital flows. Let us assume that there is free movement of capital between
India and the United States. Let the interest rates in the two countries be denoted as ri and
rU respectively. If there are no barriers on the movement of capital the two interest rates
should be the same. This however is not true. The Indian invegtors in the U.S capital
market will compare the two rates and will invest only if the U.S rate is higher than the
Indian rate. But what happens when this investment in the u.s.. matures? The Indian
investor will convert his principal and interest income from dojlar t~ rupee and in this
conversion the investor may lose if dollar depreciates against rupee (or, which is the same
thing, rupee appreciates against dollar). Let us suppose that dollar is expected to depreciate
against rupee by d %. Then the Indian investor will compare ri with P$T d, the latter being
the interest rate in the U.S. net of the expected depreciation of dollar. If capital movement
is free, then these two will be equated by the market forces: r, = rU- d. This gives us a
condition known as interest parity condition which says that the expected rate of
depreciation of dollar is equal to the difference between the U.S. interest rate and the
lndian interest rate. Thus we see that the exchange rate variations under the flexible rate
system and free capital mobility is also related to the changes in the interest rates.
4.8 FIXED EXCHANGE RATES
As mentioned above, the adjustment of a deficit in the balance of payment under the fixed
.........................................................
exchange rate system calls for official intervention in the markets. To maintain the exchange
rates fixed RBI will have to supply the excess foreign currencies demanded in the market
either from its reserves or from international borrowing. Such actions have monetary impli-
cations. The Indian importers purchase these additional foreign currencies they need for
additional imports (which is the deficit) with Indian Rupee. Thus the Indian currency
changes hand from the public to RBI through the banking system. The result is a fall in
money supply in the process of adjustment of the deficit. A fall in money supply may lead
to a fall in the price level which you may work out'by using the familiar quantity theory of
money. This improves our comparative advanta
exports become cheaper and sell
more in the world market and the cheaper substitutes replace a part of our
imports. This is how the deficit is adjusted. Remember that if all this do not happen, the
deficit which was adjusted this year bysale of foreign currencies by RBI will reappear in
the next year. Thus under the fixed exchange rate system a deficit in the balance of
payment is adjusted by money supply changes and the consequent changes in the price
level.
The link between the money supply and the price level is not as simple as that given by the
quantity theory of money. The quantity theory assumes that the economy has full employ-
ment of resources and therefore an increase in money supply creates a situation in which too
much money chases a fixed quantity of goods and services produced by the available
resources that are all fully utilised. This causes price rise. Similarly, a decrease in the
money supply reduces the aggregate demand for the fixed quantity o f goods produced by
fullyemploying the available resources leading to a decrease in the prices. But such a simple Instruments of Trade Policy
relationship between the money supply and price level does nbt hold in the Keynesian world
where the resources are not fully employed. The reason is that as money supply increases,
the aggregate supply of goods and services may increase due to the fact that the resources
are still not fully utilised and therefore the price level need not rise. Similarly, a decrease in the
supply of money does not necessarily lead to a fall in the price level. But then the question
that arises is this : if the price level is not affected by money supply due to unemployment of
resources, how would a balance of payment deficit be adjusted ? In the Keynesian model the
adjustment takes place through ihcome changes. Under the system of fixed exchange rates,
as explained in the preceding paragraph, a deficit would lead to a decrease in money supply.
This would cause an increase in the rate of interest and a fall in national hcome.To under-
stand this process you have to read a book on macroeconomics, particularly the part which
discusses the IS-LM curves. But let us try to understand the Keynesian process of adjust-
ment intuitively. A fall in the supply of money caused by the deficit will bring in a shortage in .
the credit markets : the borrowers want to bolrow but the lenders do not have enough money
balances to meet their demand for hnds. Therefore the existing supply of funds will have to
be rationed. In a market economy this rationing takes place through the price mechanism. The
lenders start charging higher rates of interest to take advantage of the shortage of funds and
some borrowers, not able to afford the higher interest rates, would opt out of the fund market.
This is the reason why the rate of interest rises as money supply falls. The higher interest
rates discourages private investment and a fall in investment reduces national income by a
multiplier effect, But the fall in income also reduces the demand for import. This last effect
eliminates the deficit and as a matter of fact the income will keep falling till import demand is
reduced sufficiently to eliminate the deficit. Thus, under the fixed exchange rate system a
deficit in the balance of payment is adjusted by a fall in the national income, if the resources
are not fully employed. This is the Keynesian theory of adjustment. The adjustment through
the changes in the price level discussed earlier is known as the classical theory of adjust-
ment
L
Check Your Progress B
1. What is Balance of Payment?
............................................................................................................
............................................................................................................
2. What do you mean by purchasing power parity theory?
...................,,,..,.,,..,.,,,..............,,,...,.,.,~.,,..,.....*...................................
............................................................................................................
...........................................................................................................
...........................................................................................................
3. What is fixed exchange rates?
............................................................................................................
 What do you mean by balance or payment. Explain the relationship between the Instruments of Tkade Pollcy
Concepts and Uimcnsions 4. State whether following statements are True or False. 4.
balance of payment and the exchange rates of a country with suitable example.
9 The difference between the value of exports and the value of imports is the
balance on trade account. 5. Write short notes on:

ii) There is a close relationship between balance o f payment and the exchange i) Consumer surplus
rates of a currency. ii) Producer surplus
iii) Rupee is said to appreciate against foreign currencies in the case of a.deficit iii) Flexible exchange rate
in the balance of payment.
iv) Fixed exchange rate.
iv) A fall in money supply may lead to a rise in the price level.
v) Under the fixed exchange rate system, a deficit in the balance of payment is
adjusted by a fall in the national income, if the resources are not fully
employed.

4.9 LET US SUM UP

Trade policy is an important instrument to regulate the foreign trade. Government impose
restrictions to protect the domestic industries. The restriction< rn:i! bc in the form of tariff
and non-tariff barriers. A tariff is a price based policy to r2\11.1~11 1 i l ~ l 2Non-tariff
. barriers
may affect either price or quantity directly. The major norl-tariff barriers include: customs
classification and valuation, subsidies, local content and tireign investment performance
requirement, Technical standards and health regulations, (;overnn~entprocurement,
Restrictions on services, quota, etc. Exchange control and balance of payment adjustments
are another means of regulating the foreign trade.

4.310 KEY WORDS

Tariff: It refers to a tax imposed by a government on physical goods as they move into or
out o f a country.

Non-Tariff Barriers: Government policies and administrative practices that regulates o r

restrict the foreign trade.

Quota: Quantitative measures of restrictions imposed by the government to regulate the

international trade.

subsidies: Payment made by the government to the domestic producers or exporters to

stimulate the expansion of such industries.

Balance of Payment: An accounting record of transactions between the residents of one

country and the residents of the rest of the world over a given period of time.

4.11 ANSWERS TO CHECK YOUR PROGRESS

A 4 i) False; ii) True; iii) True; iv) False; v) False.

B 4 i)'True; ii) True; iii) False; iv) False; v) True.

4.12 TERMINAL QUESTIONS

1. Critically examine the partial equilibrium theory o f trade.
2. Distinguish between tariff and non-tariff barriers. Explain various non-tariff
barriers to restrict the international trade.
3. Describe the impact of quota and tariff.
62 -
Concepts and Dimtnsions
-
SOME USEFUL BOOKS
Anant K. Sundaram and J. Stewart Black, The International Blrsiness Environment-Text
and Cases, Prentice Hall of India (Recent Edition), New Delhi.

Donald A. Ball and Wendell H. Me Culloch, Jr. International Business-Introduction and

Essentials, Business Publications Inc. (Recent Edition), Texas, USA.
HBO-I: INTERNATIONAL BUSINESS ENVIRONMENT
Franklin R. Root, International Trade and Investment, South Western Publishing Co.
(Recent Edition), Ohio, USA.
BLOCK UNIT UNIT TITLE
John D. Daniels and Lee H. Radebaugh, International Business-Environment and Opera- NOS.
tions, Addison Wesley (Recent Edition), New York.

Richard E. Caves,Jeffrey A. Frankel and Ronald W. James, World Trade and Payments - I CONCEPTS AND DIMENSIONS
An Introduction, Scott, Foresman and Company (Recent Edition), Illinois.
Unit- 1 Introduction to International Business Environment
Rugman and Hodgetts, International Business- A Strategic Management Approach, Unit-2 Theories of International Trade
McGraw Hill Inc. (Recent Edition), New York. .
Unit-3 Balance of Payments
' Vern Terpstra and Ravi Sarathy, Internutional Marketing, The Dryden Press (Recent Unit-4 Instruments of Trade Policy
Edition), New York, USA.
2 GLOBALIZATION: PROCESS A N D F3RCES
Unit-5 Globalization:An Overview
Unit-6 International Investment
Unit-7 Transnational Corporations
Unit-8 Technology Traosfer

3 WORLD 'I'RADENG SYSTEM AND INSTI'I'UTIBNS

Unit-9 World Trade
Unit- 10 Multilateral Trading System
Unit- 11 Regional Economic Groupings
Unit- 12 International Commodity Agreement
Unit- 13 Multilateral Financial Institutions

4 LEGAL ENVIRONMENT
Unit- 14 Legal Framework of Foreign Trade
Unit- 15 The Proper Law of Contract or the Lex Causae
Unit- 16 Settlement of International Trade Disputes

5 CONTEMPOWRY DEVEEOFILIENTS AND ISSUES

Unit-17 International Trade and Environment
Unit- 18 International Trade in Services
Unit-19 International Business Ethics
Uni t-20 Electronic Commerce