Unit 2 Economic System and International Trade

Three Basic Issues of International Trade

1) Gains from trade – The first important issue is about the gains from trade? Do
countries gain from international trade? Where do the gains come from , and how
are they divided among the trading countries?
) Structure of trade – The second relevant issue is the structure or direction or
pattern of international trade. In other words, which goods are exported and which
are imported by each trading country? What are the fundamental laws that govern
the international allocation of resources and the flow of trade?
3) Terms of trade – The third relevant issue is the terms of trade. In other words, at
what prices are the exported and imported goods exchanged?

Classical Trade Theories

Adam Smith and David Ricardo gave the classical theories of international trade.

According to the theories given by them, when a country enters in foreign trade, it
benefits from specialization and efficient resource allocation.

The foreign trade also helps in bringing new technologies and skills that lead to
higher productivity.

The assumptions taken under this theory’ are as follows:

a. There are two countries producing two goods.

b. The size of economies of these countries is equal

c. There is perfect mobility of factors of production within countries

d. Transportation cost is ignored

e. Before specialization, country’s resources are equally divided to produce each

good

The classical theories are divided into three theories, as shown

in Figure-3:
Theory of Mercantilism:
Mercantilism is the term that was popularized by Adam Smith, Father of Economics,
in his book, The Wealth of Nations. Western European economic policies were
greatly dominated by this theory. The theory of mercantilism holds that countries
should encourage export and discourage import.

It states that a country’s wealth depends on the balance of export minus import.
According to this theory, government should play an important role in the economy
for encouraging export and discouraging import by using subsidies and taxes,
respectively. In those days, gold was used for trading goods between countries.

Thus, export was treated as good as it helped in earning gold, whereas, import was
treated as bad as it led to the outflow of gold. If a nation has abundant gold, then it is
considered to be a wealthy nation. If all the countries follow this policy, there may be
conflicts, as no one would promote import. The theory of mercantilism believed in
selfish trade that is a one-way transaction and ignored enhancing the world trade.
Mercantilism was called as a zero-sum game as only one country benefitted from it.

Theory of Absolute Advantage:

Given by Adam Smith in 1776, the theory of absolute advantage stated that a
country should specialize in those products, which it can produce efficiently. This
theory assumes that there is only one factor of production that is labour.

Adam Smith stated that under mercantilism, it was impossible for nations to become
rich simultaneously. He also stated that wealth of the countries does not depend
upon the gold reserves, but upon the goods and services available to their citizens.

Adam Smith wrote in The Wealth of Nations, ”If a foreign country can supply us with
a commodity cheaper than we ourselves can make it, better buy it of them with some
part of the produce of our own industry, employed in a way in which we have some
advantage”.
He stated that trade would be beneficial for both the countries if country A exports
the goods, which it can produce with lower cost than country B and import the goods,
which country B can produce with lower cost than it.

An example can be used to prove this theory. Suppose there are two countries A
and B, which produce tea and coffee with equal amount of resources that is 200
labourers. Country A uses 10 labourers to produce 1 ton of tea and 20 labourers to
produce 1 ton of coffee. Country B uses 25 units of labourers to produce tea and 5
units of labourers to produce 1 ton of coffee.

This is shown in Table- 1:

It can be seen from Table-2 that country A has absolute advantage in producing tea
as it can produce 1 ton of tea by using less labourers as compared to country B. On
the other hand, country B has absolute advantage in producing coffee as it can
produce 1 ton of coffee by employing less labourers in comparison to country A.
Now, if there is no trade between these countries and resources (in this case there
are total 200 labourers) are being used equally to produce tea and coffee, country A
would produce 10 tons of tea and 5 tons of coffee and country B would produce 4
tons of tea and 20 tons of coffee. Thus, total production without trade is 39 tons (14
tons of tea and 25 tons of coffee).

Table-2 shows the production without the trade between country A and
country B:

If both the countries trade with each other and specialize in goods in which they have
absolute advantage, the total production would be higher. Country A would produce
20 tons of tea with 200 units of labourers; whereas, country B would produce 40 tons
of coffee with 200 units of labourers. Thus, total production would be 60 units (20
tons of tea and 40 tons of coffee).

The production of tea and coffee after trade is shown in Table-3:

Without specialization, total production of countries was 39 tons, which becomes 60
tons after specialization. Therefore, the theory of absolute advantages shows that
trade would be beneficial for both the countries.
Limitation
1. It does not take into account transportation costs involved in selling the product in
international market.

2. It is based on the assumption that exchange rates are stable which is seldom the
case and hence a limitation.

3. It also assumes that labour can switch between products easily and they will work
with same efficiency which in reality cannot happen.

4. The Absolute Advantage Theory theory assumed that only bilateral trade could
take place between nations and only in two commodities that are to be exchanged.
This assumption was significantly challenged when the trade, as well as the needs of
a nation, started increasing.

Theory of Comparative Advantage:

Many questions may come in mind after reading the absolute advantage theory that
what would happen if a country has absolute advantage in all the products or no
absolute advantage in any of the product. How such a country would benefit from
trade? The answers of these questions was given by David Ricardo in his theory of
comparative advantage, which states that trade can be beneficial for two countries if
one country has absolute advantage in all the products and the other country has no
absolute advantage in any of the products.

According to Ricardo, “…a nation, like a person, gains from the trade by exporting
the goods or services in which it has its greatest comparative advantage in
productivity and importing those in which it has the least comparative advantage. ”

This theory assumes that labour as the only factor of production in two countries,
zero transport cost, and no trade barriers within the countries. Let us understand this
theory with the help of an example.
Suppose there are two countries A and B, producing two commodities wheat and
wine with labour as the only factor of production. Now assume that both the
countries have 200 labourers and they use 100 labourers to produce wheat and 100
labourers to produce wine.

Table-4 shows the production of wheat and wine in Country X and Country Y
before trade:

Table-4 depicts that country X can produce 20 units; whereas, country Y can
produce 15 units of wheat by using 100 labourers. In addition, country X can produce
40 units; whereas, country’ Y can produce 10 units of wine by employing 100
labourers.

Thus, country X has absolute advantage in producing both the products. As already
discussed, country X employs same number of labourers (100 labourers in
production of each good) in producing both wine and wheat; however, the production
of wine is more than the production of wheat.

It shows that country’ X has comparative advantage in producing wine. Similarly,

country Y also employs same number of labourers (100 labourers in production of
each good) in manufacturing wheat and wine; however, its production of wheat is
more than the wine. It indicates that country Y has comparative advantage in
manufacturing wheat.
For example, country X has decided to produce 60 units of wine by employing 150
labourers. It uses 50 labourers to produce 10 units of wheat. On the other hand,
country Y has decided to use all the 200 labourers to produce 30 units of wheat. It
would not produce any unit of wine.

This data is represented in Table-5:

Now, country X exchanges 14 units of wine with 14 units of wheat produced by

country Y.

The situation of both the countries after trade is shown in Table-6:

 It can be observed from Table-6 that both the countries have gained from trade.
Before trade, country X has 20 units of wheat and 40 units of wine; however, after
trade, country X has 24 units of wheat and 46 units of wine.

On the other hand, country Y has 15 units of wheat and 10 units of wine before
trade; however, it has 16 units of wheat and 14 units of wine after trade. Therefore,
comparative advantage explains that trade can create benefit for both the countries
even if one country has absolute advantage in the production of both the goods.

CRITICISMS OF COMPARATIVE ADVANTAGE

1. The theory only considers labour costs and neglects all non-labour costs involved in
the production of the commodities.
2. The theory considers all labour to be homogenous. However, in reality, labour is
heterogeneous due to different grades and kinds.
3. The theory assumes similar tastes for all. However, the tastes differ with the growth
of economies and income brackets.
4. The theory assumes that a fixed proportion of labour is used in the production of all
commodities. However, in reality, utilization of the proportion of labour depends on
the type of commodity being produced.
5. The theory has an unrealistic assumption of constant costs. However, large-scale
productions lead to cost reduction and thereby increase the comparative advantage

MODERN THEORY OF INTERNATIONAL TRADE

One of the main drawbacks of Ricardian theory of comparative cost was that it did
not explain why differences in comparative costs exist.

In 1919, Eli Heckscher propounded the idea that trade results from differences in
factor endowments in different countries The idea was further carried forward and
developed by Bertil Ohlin in 1933 in his famous book Inter-regional and International
Trade. This book forms the basis for what is known as Heckscher – Ohlin theory or
modern theory of international trade.

Heckscher – Ohlin Theory

The Heckscher – Ohlin theory is based on most of the assumptions of the classical
theories of international trade and leads to the development of two important
theorems – (a) Heckscher – Ohlin theorem and (b) Factor price equalization
theorem.
 Heckscher Ohlin's (HO) Modern Theory of
International Trade
Introduction To Heckscher Ohlin's H-O Theory ↓

The Modern Theory of international trade has been advocated by Bertil Ohlin. Ohlin
has drawn his ideas from Heckscher's General Equilibrium Analysis. Hence it is also
known as Heckscher Ohlin (HO) Model / Theorem / Theory.

According to Bertil Ohlin, trade arises due to the differences in the relative prices of
different goods in different countries. The difference in commodity price is due to the
difference in factor prices (i.e. costs). Factor prices differ because endowments (i.e.
capital and labour) differ in countries. Hence, trade occurs because different
countries have different factor endowments.
The Heckscher Ohlin theorem states that countries which are rich in labour will
export labour intensive goods and countries which are rich in capital will export
capital intensive goods.

Assumptions of Heckscher Ohlin's H-O Theory ↓

Heckscher-Ohlin's theory explains the modern approach to international trade on the

basis of following assumptions :-

1. There are two countries involved.

2. Each country has two factors (labour and capital).
3. Each country produce two commodities or goods (labour intensive and capital
intensive).
4. There is perfect competition in both commodity and factor markets.
5. All production functions are homogeneous of the first degree i.e. production
function is subject to constant returns to scale.
6. Factors are freely mobile within a country but immobile between countries.
7. Two countries differ in factor supply.
8. Each commodity differs in factor intensity.
9. The production function remains the same in different countries for the same
commodity. For e.g. If commodity A requires more capital in one country then
same is the case in other country.
10. There is full employment of resources in both countries and demand are identical
in both countries.
11. Trade is free i.e. there are no trade restrictions in the form of tariffs or non-tariff
barriers.
12. There are no transportation costs.
Given these assumption, Ohlin's thesis contends that a country export goods which
use relatively a greater proportion of its abundant and cheap factor. While same
country import goods whose production requires the intensive use of the nation's
relatively scarce and expensive factor.
 Understanding The Concept of Factor Abundance ↓

In the two countries, two commodities & two factor model, implies that the capital rich
country will export capital intensive commodity and the labour rich country will export
labour intensive commodity. But the concept of country being rich in one factor or
other is not very clear. Economists quite often define factor abundance in terms of
factor prices. Ohlin himself has followed this approach. Alternatively factor
abundance can be defined in physical terms. In this case, physical amounts of
capital & Labour are to be compared.

• Price Criterion for defining Factor Abundance ↓

A country where capital is relatively cheaper and labour is relatively costly is said to
be capital rich country. Whereas a country where labour is relatively cheaper and
capital is relatively costly is said to be labour rich country.
Price of the factor can be symbolically measured as follows :-

In above relation,
1. P refers to price of the factor,
2. K refers to Capital,
3. L refers to Labour,
4. E stands for England, and
5. I stands for India.
Note:- In reality, England is not a country else a part of United Kingdom (U.K).
England is called a country in this article just for the sake of learning example.

The above analysis highlights a fact that in England capital is cheap, and hence it is
a capital abundant country. Whereas in India, Labour is cheaper, and thus it is a
labour rich country.
Now lets understand how such a pattern of trade will necessarily emerge.
 • Diagram Explaining Heckscher Ohlin's H-O Theory ↓

Let us take an example of same two countries viz; England and India where England
is a capital rich country while India is a labour abundant nation.
In the above diagram XX is the isoquant (equal product curve) for the commodity X
produced in England. YY is the isoquant representing commodity Y produced in
India. It is very clear that XX is relatively capital intensive while YY is relatively labour
incentive. The factor capital is represented on Y-axis while the factor labour is
represented on the horizontal X-axis.
PA is the price line or budget line of the country England. The price line PA is
tangent to XX at E. The price line PA is also tangent to YY isoquant at K. The point K
will help us to find out how much of capital and labour is required to produce one unit
of Y in England.
P1B is the price line of the country India, The price line P1B is tangent to YY at I. The
price line RS which is drawn parallel to P1B is tangent to XX at M. This will help us to
find out how much of capital and labour is required to produce one unit of commodity
X in India.
Under the given situations, the country England will choose the combination E.
Which means more specialisation on capital goods. It will not choose the
combination K because it is more labour intensive and less capital intensive.
Thus according to Ohlin, England will specialise on production of goods X by using
the cheap factor capital extensively while India specialises on commodity Y by using
the cheap factor labour available in the country.
The Ohlin's theory concludes that :-
1. The basis of internal trade is the difference in commodity prices in the two
countries.
2. Differences in the commodity prices are due to cost differences which are the
results of differences in factor endowments in two countries.
3. A capital rich country specialises in capital intensive goods & exports them. While
a Labour abundant country specialises in labour intensive goods & exports them.

Limitations of Heckscher Ohlin's H-O Theory ↓

Heckscher Ohlin's Theory has been criticised on basis of following grounds :-

1. Unrealistic Assumptions : Besides the usual assumptions of two countries, two
commodities, no transport cost, etc. Ohlin's theory also assumes no qualitative
difference in factors of production, identical production function, constant return to
scale, etc. All these assumptions makes the theory unrealistic one.
2. Restrictive : Ohlin's theory is not free from constrains. His theory includes only
two commodities, two countries and two factors. Thus it is a restrictive one.
3. One-Sided Theory : According to Ohlin's theory, supply plays a significant role
than demand in determining factor prices. But if demand forces are more
significant, a capital abundant country will export labour intensive good as the
price of capital will be high due to high demand for capital.
4. Static in Nature : Like Ricardian Theory the H-O Model is also static in nature.
The theory is based on a given state of economy and with a given production
function and does not accept any change.
5. Wijnholds's Criticism : According to Wijnholds, it is not the factor prices that
determine the costs and commodity prices but it is commodity prices that
determine the factor prices.
6. Consumers' Demand ignored : Ohlin forgot an important fact that commodity
prices are also influenced by the consumers' demand.
7. Haberler's Criticism : According to Haberler, Ohlin's theory is based on partial
equilibrium. It fails to give a complete, comprehensive and general equilibrium
analysis.
8. Leontief Paradox : American economist Dr. Wassily Leontief tested H-O theory
under U.S.A conditions. He found out that U.S.A exports labour intensive goods
and imports capital intensive goods, but U.S.A being a capital abundant country
must export capital intensive goods and import labour intensive goods than to
produce them at home. This situation is called Leontief Paradox which negates H-
O Theory.
9. Other Factors Neglected : Factor endowment is not the sole factor influencing
commodity price and international trade. The H-O Theory neglects other factors
like technology, technique of production, natural factors, different qualities of
labour, etc., which can also influence the international trade.

Factor Price Equalisation Theorem (FPET) | Free Trade | Economics

The factor price equalisation theorem suggests a even if the mobility of factors is
limited by national frontiers, free trade in commodities helps to even out disparities in
demand relative to supply of factors, and to diminish the discrepancy between factor
returns among countries.

Two or more countries sharing the same technology will find that free trade brings
factor returns to absolute equality even if their endowments are sufficiently similar
and they produce in common a sufficient number of commodities (at least equal to
the number of distinct productive factors).

As Caves Frankel and Jones put it: “If countries share a common technology,
free trade n commodities’ serves to equalize factor returns despite our assumption
that factor movements are purely national and no international factor mobility is
allowed.”

The Effect of International Trade on Factor Prices:

Let us illustrate the FPET by assuming that there are two countries’ viz America
(which is capital-abundant) and Britain (which is labour-abundant). Steel is the
capital-intensive product and doth is the labour-intensive in nature.

Both countries produce two commodities, viz, steel and cloth In other words,
specialisation is not complete in any country. Paul Samuelson has proved
conclusively that even in the absence of factor mobility between countries free
commodity trade leads to the equalisation of real factor rewards between two
countries.

With free commodity trade, workers can earn the same real wage and capital the
same real rental in both America and Britain. This is the effect of free trade in
commodities on factor prices

In essence the HOT model refers to an indirect exchange of factors between

countries. By exporting labour-intensive commodity (steel), the labour-abundant
country (Britain) indirectly exports a certain amount of labour in exchange for a
certain amount of capital. And the capital- abundant country does the opposite.

This indirect exchange of labour raises the real wage rate in Britain and lowers the
rate in America. It also lowers the real rental rate in Britain and raises it in America.
Thus the HOT implies that factors do indeed migrate between countries not directly,
but through the exports and imports of commodities.
Factor Prices and Commodity Prices:
As labour becomes relatively cheap (i.e., as the wage-rental ratio falls), the labour-
intensive commodity (cloth) becomes cheaper relative to the capital-intensive
commodity (steel).

Figure 1 shows the unit isoquants for cloth and steel. At the initial factor prices,
shown by the isocost line AB, the steel industry uses factor combination S, and the
cloth industry C per unit of output. When the wage rate falls the isocost lines become
flatter, shown by the dotted lines through S’ and C’. At the new wage-rental ratio, the
steel industry will choose S’ and the cloth industry C’.

Since C’ lies on a lower isocost line than S’, at the lower wage-rental ratio, cloth
becomes relatively cheaper than steel. This means that as the wage rate falls, the
relative price of cloth also falls as long as cloth is labour-intensive relative to steel.

Proof of FPET:
In Figure 2, the upward sloping curve PW shows the basic relationship between
factor prices and commodity prices. As the wage-rental ratio falls from, say OF two
OM, the relative price of cloth (the labour-intensive commodity) falls from OS to ON.
Under autarky, America operates at A and Britain at B. With free trade, America
exports steel and Britain cloth.

At the equilibrium relative price of cloth, ON, the same wage-rental ratio prevails in
both countries since the marginal physical products of labour and capital are
equalized between countries through forces of competition which lead to equalization
of commodity prices.
Movement of Commodities as a Substitute of Factor Movement:
Thus, equalisation of commodity prices between two countries leads to equalisation
of factor prices since movement of commodities under free trade acts as a substitute
for the movement of factors of production. Thus, even in the absence of factor
mobility, factor prices tend towards equalisation.

Incomplete Specialisation of FPE:

The equalisation of commodity prices (brought about by free commodity trade)
implies that for any commodity price ratio a country produces both steel and cloth;
the wage-rental ratio will also be the same for both countries. The reason is that the
real factor prices are given by their respective marginal products of the two factors.

Since the production function in each country shows CRS, these marginal
productivities depend only on the proportion in which labour and capital are used in
the production of both the commodities—not on the absolute amount of labour and
capital employed in each country.

Furthermore, in each industry capital-labour ratio is perfectly determined where the

wage- rental ratio is given. Since both countries have identical production functions
(by assumption), the equalization of the wage-rental ratio between America and
Britain necessarily equates America’s marginal physical product of labour and capital
to the corresponding marginal products of Britain.

The logic of the FPET for the simple 2 x 2 case can be stated briefly. In a competitive
equilibrium, unit cost equals price if the commodity is produced. Thus let A represent
the matrix of input-output coefficients, aij, w the vector (pair) of factor prices and p
the vector (pair) of commodity prices.
Technique need not be constant: in general they depend upon prevailing factor
prices so that A = A (w). Therefore the competitive profit conditions if both goods are
actually produced dictate that

A (w). w -p … (1)

Assuming no factor-intensive reversal, A (w) is non-singular. Therefore, if countries

share the same technology, and face the same pair of free trade commodity prices,
they must face exactly the same set of actor prices if each country produces both the
goods, i.e., if specialisation is incomplete. The crucial issue in the factor price
equalisation argument is the unique dependence of factor price vector w and
commodity price vector p.

In the 2 x 2 case, uniqueness is a simple question. It depends on factor intensities

differing between sectors and not reversing. But this is not the only issue.

The question of uniqueness involves properties of technology alone, whereas under

appropriate circumstances, two countries engaged in free trade will have factor
prices equalised only if factor endowments are relatively similar. For if factor
endowments are too dissimilar, it will be impossible for both countries to produce
both commodities, in which case, the equality in (1) cannot universally hold.

The Cone of Diversification:

These ideas can be made more precise by considering a concept, called by John
Chipman the cone of diversification. For any factor price vector w, there is
determined a pair of techniques (labour/capital ratios) for the two commodities. Both
factors can be fully employed only if the country’s endowment vector is contained
within the cone spanned by these techniques.

Suppose two countries face a common free trade commodity price vector, p , and
that the commonly shared technology associates a unique factor price w
corresponding to this p. Then if the endowment vectors of both countries lie within
the cone of diversification then, their factor prices must be equalized. Thus
incomplete specialisation is a necessary condition for the FPET to hold. Two other
conditions for it to hold are (1) identical production function and (2) CRS.

Significance of the Theorem:

The equalisation of real factor rewards between countries is an important Pareto-
optimal condition for the efficient allocation of resources worldwide. In a like manner,
efficient resource allocation within a closed economy requires that identical units of
the same homogeneous factors earn the same returns, efficient resource allocation
in the world requires complete factor price equalisation.
Limitations of Sameulson’s Approach:
According to caves, Frankel and Jones, the EPET may not always hold even if
countries do indeed share the same technology. The FPET presumes that factor
endowment proportion do not differ much between countries, i.e., all countries have
more or less similar endowments.

As Fig 3 illustrates, v, k and k* are the ratios in two countries, their factor prices
cannot be equalized with trade. If the capital labour endowment ratios in Britain is k,
the wage/rental ratio must lie in the range DC.

If the capital—abundant country has the endowment ratio k* there is an overlap of

possible wage/rental ratios in the two countries, over the range DC. Free trade may
equalize factor prices. If the US endowment ratio is higher (***), the relative wage
rate in the USA will be higher than in Britain.

Conclusion:
With free trade, at least one of the countries must be completely specialized, and the
trade pattern must correspond to the H-O dictum that relatively capital-abundant
countries must export capital-intensive goods.

In short, two countries that share the common technology but differ in their
endowments of the basic factors of production may nevertheless find that free trade
in commodities forces wage rates and rental rates in two countries into absolute
equality.

Terms of trade
Definition/Meaning and Explanation:

By terms of trade, is meant terms or rates at which the products of one country are
exchanged for the products of the other. It is known to us that every country has got
its own money. The currency of one country is not legal tender in the other country.
So every country has to export commodities in order to import goods.

"The rate at which given volume of exports Is exchanged for a given quantity of
imports is called the commodity terms of trade".

The rate of exchange or the term of exchange depends upon the elasticities of the
demand of each country for the products of the other.
For instance, if Pakistan's demand for Indian's wheat is much more intense than
Indian's demand for Pakistan's cotton, the terms of trade will be more favorable to
India than to Pakistan. This is because Pakistan's demand for India's wheat is highly
inelastic while India's demand for Pakistan's cotton is highly elastic.

The country which is more eager to sell or purchase stands at disadvantage in the
bargain. In the words of Taussing:

"That country gains more from international trade whose exports are more in
demand and which itself has little demand for the things it imports, i.e., for the
exports of the other countries, that country gains least which has the most insistent
demand for the products of the other country".

That terms of trade are measured by the ratio of import prices to export prices. The
terms of trade will be favourable to a country when the export prices are high
relatively to import prices. This is because the products of one unit of domestic
resources will exchange against the product of more than one unit of foreign
exchange. If, on the other hand, the prices of its imports rise relatively to the prices
of its exports, the terms of trade will be unfavourable to the country.

Equation/Formula:

The terms of trade can be expressed in the form of equation as such:

Terms of Trade = Price of Imports and Volume of Imports

Price of Exports and Volume of Exports

The terms of trade are of economic significance to a country. If they are favorable to
a country, it will be gaining more from international trade and if they are unfavorable,
the loss will be occurring to it. When the country's goods are in high demand from
abroad, i.e., when its terms of trade are favorable, the level of money income
increases. Conversely, when the terms of trade are unfavorable, the level of money
income falls.
Measurement of Change in Terms of Trade:

The changes in terms of trade can be measured by the use of an import and export
index number. We here take only standardized goods which have internal market
and give them weight according to their importance in the international transactions.
A certain year is taken as base year and the average of the countries import and
export prices of the base year is called 100. We then work out the index of
subsequent year. These indices then show as to how the commodity terms of trade
move between two countries. The ratio of exchange in export prices to the change in
import prices is put in the form of an equation as under:

Commodity Terms of Trade = Change in Export Prices

Change in Import Price
Algebraically, it can be expressed:

Te = Px1 ÷ Pm1
Pxo Pmo
Here:

Te Represents commodity terms of trade.

Px1 Represents export price index for the required year.

Px° Represents exports price index of the base year.

Pm1 Represents indices of prices of the required year.

Pm° Represents indices of prices for the base year.

We now apply the above formula by taking a specific example. We take the indices
of export and import prices for the year 1982 as 100. We assume also that the export
prices index for the year 1982 is 330 and import prices index 380. The ratio of
change in export prices to the change in import prices will be:

Te = 300 ÷ 380
100 100

Te = 330 x 300
100 380

Te = 0.87

The above example shows that the prices of imports have increased more than the
exports prices. The terms of trade are unfavorable to the country by 13%. In other
words, the country has to pay 13% more for a given amount of imports.

Income Terms of Trade:

It is the desire of every country that it should earn the maximum of income out of
international exchange by taking permanent favorable terms of trade. In order to
secure maximum gain, the country will try to increase the volume and value of
exports and reduce the volume of imports and buy it also from the cheapest market.
If the country is having a monopoly in the supply of a commodity and the demand for
products is inelastic, then it can fetch more income. Incase the terms of trade move
against the country, then there will be drain of national income, the commodity terms
of trade depend upon the following factors:

(i) Ratio of import prices to export prices.

(ii) The volume and value of exports and imports.

(iii) The condition attached to export and import such as insurance charges, supply
of machinery and shipping, etc.

If the terms of trade are favourable which may be due to monopolistic supply or
inelastic demand or cheap and better kind of exports, etc., the terms of trade will be
favourable and the national income will rise. In case of terms of trade are
unfavourable over a period of time, the national income will fall.

Gains From International Trade

The gains from international trade arise because of the diversity in the conditions
of production (natural or acquired) in different countries. Each country tries to
specialize in the production of those commodities in which its comparative cost
advantage is greatest or the comparative disadvantage is the least. It realizes gain
by exporting those commodities which it has a relative advantage over other
countries.

The gain from international trade can arise only if the opportunity cost ratio between
two commodities is different. If the substitute ratio is the same, no advantage can
occur to any country. This can be illustrated by taking numerical examples.

Example:

(1) Equal Difference in Substitute Ratio: Let us suppose in Pakistan one unit of
productive resources produces either one quintal of cotton, or half quintal of wheat.
Suppose further that India, with one unit of resources is also able to produce either
one quintal of cotton or half quintal of wheal. Will specialization or exchange be of
any advantage to India and Pakistan? The answer is No. If Pakistan and India invest
two units of productive resources separately in their own countries, the total
production will be:

Pakistan: 1 quintal of cotton + 1/2 quintal of wheat.

India: 1 quintal of Cotton + 1/2 quintal of wheat.

Total product = 2 quintal of cotton + 1 quintal of wheat without specialization.

If Pakistan specializes in the production of cotton and India in wheat the total
production will be:

Pakistan: 2 quintals of cotton.

India: 1 quintal of wheat.

When the opportunity cost ratio between two countries is the same, no benefit can
occur through specialization to the countries concerned. If Pakistan specializes in the
production of cotton and India in wheat, Pakistan will gain only if she can get more
than 1/2 quintal of wheat for one quintal of cotton from India.

India won't agree to it because in her own country she can get one quintal of cotton
for 1/2 quintal of wheat, India can only gain if she pays less than 1/2 quintal of wheat
for one quintal of cotton to Pakistan.
To this bargain, Pakistan won't agree because by transferring productive resources
from cotton to what she can produce that much at home. Thus, we find, that when
comparative cost ratio between two countries is the same, no gain can arise from
international trade.

(2) Difference in Comparative Cost Ratio: When comparative cost ratio in two
countries differs, then gain arises from international trade, let us suppose now that
with one unit of resource Pakistan produces either one quintal of cotton or 10
quintals of wheat. India with the same resources produces either one quintals of
cotton or 25 quintals of wheat. If Pakistan and India invest their resources in their
own countries separately for the production of cotton and wheat, the total production
will be:
Pakistan: 1 quintal of cotton + 10 quintal of wheat.

India: 1 quintal of cotton + 25 quintal of wheat.

Total = 2 quintals of cotton + 35 quintals of wheat.

If Pakistan specializes in the production of cotton and India in wheat, the total
product with the same productive resources will be:

Pakistan: 2 quintals of cotton.

India: 50 quintal of wheat.

We find thus that when opportunity cost ratio is different between two countries, the
same productive resources can be made to yield a surplus of 15 quintals of wheat.
This surplus of 15 quintals of wheat can be mutually shared by Pakistan and India. If
Pakistan's demand for India's wheat is inelastic, terms of trade will be more in India's
favour. In case Pakistan's demand for wheat is elastic, then the terms of trade will be
more in its favour.

Similarly, if India's demand for Pakistan's cotton is inelastic, the terms of trade will
move against India. Let us now go back to actual exchange. If Pakistan's demand for
India's wheat is inelastic, the rate of exchange will settle somewhere near 11 quintals
of wheat for one quintal of cotton and if India's demand for Pakistan's cotton is
inelastic, then the rate of exchange will settle somewhere near 24 quintals of wheat
for one quintal of cotton. The actual rate of exchange will settle on the intensity of
reciprocal demands, and it will remain within two extreme limits, i.e., 10 and 25
quintals.

In our example given above, the difference in the cost ratio is small therefore, the
gain enjoyed by the trading countries is not much. The greater the difference in the
cost ratio, the larger is the total gain. In the words of Harrod:

"A country gains by foreign trade if and when the traders find that there exists abroad
a ratio of prices very different from that to which they are accustomed at home. They
buy what to them seems cheap and sell what to them seems dear. The bigger the
gap between what to them seems low point and high point and the more important
the article affected, the greater will be the gain from trade. Prof. Ohlin, on he other
hand, is of the opinion that the amount of gain from international trade is very
complicated. He doubts if the gain from international trade will at all be measured
although he does not doubt the existence of such gains".

Factors affecting gains from trade

There are several factors which determine the gains from international trade:

1. Differences in cost ratio: The gains from international trade depends upon the
cost ratios of differences in comparative cost ratios in the two trading
countries. The smaller the difference between exchange rate and cost of
production the smaller the gains from trade and vice versa.
2. Demand and supply: If a country has elastic demand and supply gains the
gains from trade are higher than if demand and supply are inelastic.
3. Factor availability: International trade is based on the specialization and a
country specializes depending upon the availability of factors of production. It
will increase the domestic cost ratios and thereby the gains from trade.
4. Size of country: If a country is small in size it is relatively easy for them to
specialize in the production of one commodity and export the surplus
production to a large country and can get more gains from international trade.
Whereas if a country is large in size then they have to specialize in more than
one good because the excess production of only one commodity can not be
exported fully to a small sized country as the demand for good will reduce
very frequently. So the smaller the size of the country, the larger the gain
from trade.
5. Terms of Trade: Gains from trade will depend upon the terms of trade. If the
cost ratio and terms of trade are closer to each other more will be the gains
from trade of the participating countries.
6. Productive Efficiency: An increase in the productive efficiency of a country
also determines its gains from trade as it lowers the cost of production and
price of the goods. As a result, the country importing gains by importing
cheap goods.

Globalization of Trade
Trade globalization is a type of economic globalization and a measure (economic
indicator) of economic integration. On a national scale, it loosely represents the
proportion of all production that crosses the boundaries of a country, as well as the
number of jobs in that country dependent upon external trade. On a global scale, it
represents the proportion of all world production that is used for imports and exports
between countries.
 For an individual country, trade globalization is measured as the
proportion of that country's total volume of trade to its Gross Domestic
Product (GDP):
Imports + Exports
GDP
  For the world as a whole, trade globalization is the share of total world
trade in total world production (GDP), where the sums are taken over
all countries:
∑Exports
∑GDP

Trade Policy: Free Trade and Protection

I. Free Trade:
International trade that takes place without barriers such as tariff, quotas and foreign
exchange controls is called free trade. Thus, under free trade, goods and services
flow between countries freely. In other words, free trade implies absence of
governmental intervention on international exchange among different countries of the
world.

1. Arguments for Free Trade:

(i) Advantages of specialisation:
Firstly, free trade secures all the advantages of international division of labour. Each
country will specialise in the production of those goods in which it has a comparative
advantage over its trading partners. This will lead to the optimum and efficient
utilisation of resources and, hence, economy in production.

(ii) All-round prosperity:

Secondly, because of unrestricted trade, global output increases since
specialisation, efficiency, etc. make production large scale. Free trade enables coun-
tries to obtain goods at a cheaper price. This leads to a rise in the standard of living
of people of the world. Thus, free trade leads to higher production, higher
consumption and higher all-round international prosperity.

(iii) Competitive spirit prevails:

Thirdly, free trade keeps the spirit of competition of the economy. As there exists the
possibility of intense foreign competition under free trade, domestic producers do not
want to lose their grounds. Competition enhances efficiency. Moreover, it tends to
prevent domestic monopolies and free the consumers from exploitation.

(iv) Accessibility of domestically unavailable goods and raw materials:

Fourthly, free trade enables each country to get commodities which it cannot
produce at all or can only produce inefficiently. Commodities and raw materials
unavailable domestically can be procured through free movement even at a low
price.
(v) Greater international cooperation:
Fifthly, free trade safeguards against discrimination. Under free trade, there is no
scope for cornering raw materials or commodities by any country. Free trade can,
thus, promote international peace and stability through economic and political
cooperation.

(vi) Free from interference:

Finally, free trade is free from bureaucratic interferences. Bureaucracy and
corruption are very much associated with unrestricted trade.

In brief, restricted trade prevents a nation from reaping the benefits of specialisation,
forces it to adopt less efficient production techniques and forces consumers to pay
higher prices for the products of protected industries.

2. Arguments against Free Trade:

Despite these virtues, several people justify trade restrictions.

Following arguments are often cited against free trade:

(i) Advantageous not for LDCs:
Firstly, free trade may be advantageous to advanced countries and not to backward
economies. Free trade has brought enough misery to the poor, less developed
countries, if past experience is any guide. India was a classic example of colonial
dependence of UK’s imperialistic power prior to 1947. Free trade principles have
brought colonial imperialism in its wake.

(ii) Destruction of home industries/products:

Secondly, it may ruin domestic industries. Because of free trade, imported goods
become available at a cheaper price. Thus, an unfair and cut-throat competition
develops between domestic and foreign industries. In the process, domestic
industries are wiped out. Indian handicrafts industries suffered tremendously during
the British regime.

(iii) Inefficient industries remain perpetually inefficient:

Thirdly, free trade cannot bring all-round development of industries. Comparative
cost principle states that a country specialises in the production of a few com-
modities. On the other hand, inefficient industries remain neglected. Thus, under free
trade, an all-round development is ruled out.
(iv) Danger of overdependence:
Fourthly, free trade brings in the danger of dependence. A country may face
economic depression if its international trading partner suffers from it. The Great
Depression that sparked off in 1929-30 in the US economy swept all over the world
and all countries suffered badly even if their economies were not caught in the grip of
depression. Such overdependence following free trade becomes also catastrophic
during war.

(v) Penetration of harmful foreign commodities:

Finally, a country may have to change its consumption habits. Because of free trade,
even harmful commodities (like drugs, etc.) enter the domestic market. To prevent
such, restrictions on trade are required to be imposed.

In view of all these arguments against free trade, governments of less developed
countries in the post-Second World War period were encouraged to resort to some
kind of trade restrictions to safeguard national interest.

II. Protection:
By protection we mean restricted trade. Foreign trade of a country may be free or re-
stricted. Free trade eliminates tariff while protective trade imposes tariff or duty.
When tariffs, duties and quotas are imposed to restrict the inflow of imports then we
have protected trade. This means that government intervenes in trading activities.

Thus, protection is the anti-thesis of free trade or unrestricted trade. Government

imposes tariffs on ad valorem basis or imposes quota on the volume of goods to be
imported. Sometimes, export taxes and subsidies are given to domestic goods to
protect them from foreign competition. These are the various forms of protection
used by modern governments to restrict trade.

Now an important question arises what forces the government to protect trade?
What are the chief arguments for protection? Can protection deliver all the goods
that a nation needs?

Arguments for Protection:

The concept of protection is not a post-Second World War development. Its origin
can be traced to the days of mercantilism (i.e., 16th century). Since then various
arguments have been made in favour of protection.

The case for protection for the developing countries received a strong support from
Argentine economist R. D. Prebisch and Hans Singer in the 1950s.
All these arguments can be summed up under three heads:
(i) Fallacious or dubious arguments;

(ii) Economic arguments; and

(iii) Non-economic arguments.

(i) Fallacious Arguments:

Fallacious arguments do not stand after scrutiny. These arguments are dubious in
nature in the sense that both are true. ‘To keep money at home’ is one such
fallacious argument. By restricting trade, a country need not spend money to buy
imported articles. If every nation pursues this goal, ultimately global trade will
squeeze.

(ii) Economic Arguments:

(a) Infant industry argument:
Perhaps the oldest as well as the cogent argument for protection is the infant
industry argument. When the industry is first established its costs will be higher. It is
too immature to reap economies of scale at its infancy. Workers are not only
inexperienced but also less efficient. If this infant industry is allowed to grow inde-
pendently, surely it will be unable to compete effectively with the already established
industries of other countries.

Thus, an infant industry needs protection of a temporary nature and over time will
experience some sort of ‘learning effect’. Given time to develop an industry, it is quite
likely that in the near future it will be able to develop a comparative advantage,
withstand foreign competition and survive without protection.

It is something like the dictum: Nurse the baby, protect the child, and free the adult.
Once an embryonic industry gets matured it can withstand competition. Competition
improves efficiency. Once efficiency is attained, protection may be withdrawn. Thus,
an underdeveloped country attempting to have rapid industrialisation needs
protection of certain industries.

However, in actual practice, the infant industry argument, even in LDCs, loses some
strength. Some economists suggest production subsidy rather than protection of
certain infant industries. Protection, once granted to an industry, continues for a long
time. On the other hand, subsidy is a temporary measure since continuance of it in
the next year requires approval of the legislature.
Above all, expenditure on subsidy is subject to financial audit. Thus, protection is
something like a “gift”. Secondly, protection saps the self-sufficiency outlook of the
protected industries. Once protection is granted, it becomes difficult to withdraw it
even after attaining maturity. That means infant industries, even after maturity, get
‘old age pension’.

In other words, infant industries become too much dependent on tariffs and other
countries. Thirdly, it is difficult to identify potential comparative advantage industries.
A time period of 5 to 10 years may be required by an industry to achieve maturity or
self-sufficiency. Under the circumstances, infant industry argument loses force.

In view of these criticisms, it is said by experts that the argument “boils down to a
case for the removal of obstacles to the growth of the infants. It does not
demonstrate that a tariff is the most efficient means of attaining the objective.”

These counter-arguments, however, do not deter us to support the growth of infant

industries in less developed countries by means of tariff, rather than subsidies.

(b) Diversification argument:

As free trade increases specialisation, so protected trade brings in diversified
industrial structure. By setting up newer and variety of industries through protective
means, a country minimises the risk in production. Comparative advantage principle
dictates narrow specialisation in production.

This sort of specialisation is not only undesirable from the viewpoint of economic
development, but also a risky proposition. Efficiency in production in some products
by some countries (e.g., coffee of Brazil, milk product of New Zealand, oil of Middle
East countries) results in overdependence on these products.

If war breaks out, or if political relations between countries change, or if recessionary

demand condition for the product grows up abroad, the economies of these
industries will be greatly injured. Above all, this sort of unbalanced industrial growth
goes against the spirit of national self-sufficiency. Protection is the answer to this
problem. A government encourages diverse industries to develop through protective
means.

However, a counter-argument runs. Politics, rather than economics, may be the

criterion for the selection of industries to be protected in order to produce
diversification at a reasonable cost. But, one must not ignore economics of
protection.
(c) Employment argument:
Protection can raise the level of employment. Tariffs may reduce import and, in the
process, import-competing industries flourish. In addition, import- substituting
industries—the substitution of domestic production for imports of manufactures—
develop. The strategy of import-substituting industrialisation promotes domestic
industry at the expense of foreign industries.

Thus, employment potential under protective regime is quite favourable. In brief, tariff
stimulates investment in import-competing and import substitution industries. Such
investment produces favourable employment multiplier.

But cut in imports following import substituting industrialisation strategy may ulti-
mately cause our exports to decline.

(d) Balance of payments argument:

A deficit in the balance of payments can be cured by curtailing imports. However,
imports will decline following a rise in tariff rate provided other trading partners do not
retaliate by imposing tariff on a country’s export. However, import restrictions through
tariff may be uncalled for if the balance of payments crisis becomes serious and
chronic. In view of this and other associated problems of tariff, it is said that tariff is a
second best policy.

(e) Anti-dumping argument:

Usually, we hear about unfair competition from firms of low-cost countries. One
particular form of unfair competition is dumping which is outlawed by international
trade pacts, such as WTO. Dumping is a form of price discrimination that occurs in
trade. Dumping occurs when a country sells a product abroad at a low price because
of competition and at a high price in the home market because of monopoly power.

In other words, dumping is a kind of subsidy given to export goods. This unfair
practice can be prevented by imposing tariff. Otherwise, workers and firms
competing with the dumped products will be hit hard.

(f) Strategic trade advantage argument:

It is argued that tariffs and other import restrictions create a strategic advantage in
producing some new products having potential for generating some net profit. There
are some large firms who prevent entry of new firms because of the economies of
large scale production. Thus, these large firms reap pure profits over the long run
during which new firms may not dare enough to compete with these established
large firms. Thus, the large scale economies themselves prevent entry of new firms.

But as far as new products are concerned, a new firm may develop and market
these products and reap substantial profit. Ultimately, successful new firms
producing new products become one of the few established firms in the industry.
New firms showing potential for the future must be protected. “If protection in the
domestic market can increase the chance that one of the protected domestic firms
will become one of the established firms in the international market, the protection
may pay off.”

(iii) Non-Economic Arguments:

(a) National defence argument:
There are some industries which may be inefficient by birth or high cost due to many
reasons and must be protected. This logic may apply to the production of national
defence goods or necessary food items. Whatever the cost may be, there is no
question of compromise for the defence industry since ‘defence is more important
than opulence’. Dependence on foreign countries regarding supply of basic food
items as well as defence products is absolutely unwise.

However, objections against this argument may be cited here. It is difficult to identify
a particular item as a defence industry item because we have seen that many
industries— from garlic to clothespin—applied for protection on defence grounds.
Candlestick-maker (for emergency lighting) and toothpick-maker (to have good
dental hygiene for the troops) demanded protection at different times at different
places. A nation which builds up its military strength through tariff protection does not
sound convincing. Thus, tariff is a second-best solution.

(b) Miscellaneous arguments against protection:

There are some good ‘side effects’ or ‘spillover effects’ of protection. This means that
it produces some undesirable effects on the economy and the basic objective of pro-
tection can be attained rather in a costless manner by other direct means other than
protection. That is, protection is never more than a second-best solution.

Firstly, protection distorts the comparative advantage in production. This means that
specialisation in production may be lost if a country imposes tariff. All these lead to
squeezing of trade. Secondly, it imposes a cost on the society since consumers buy
goods at a high price. Thirdly, often weak declining industries having no potential fu-
ture stay on the economy under the protective umbrella. Fourthly, international
tension often escalates, particularly when tariff war begins.

Usually, a foreign country retaliates by imposing tariff on its imports from the tariff-
imposing country. Once the retaliatory attitude (i.e., ‘beggar-my-neighbour policy’)
develops, benefits from protection will be lost. Finally, protection encourages
bureaucracy. Increase in trade restrictions means expansion of governmental activity
and, hence, rise in administrative cost. Bureaucracy ultimately leads to corruption.

III. Conclusion:
The classical golden age of free trade no longer exists in the world. But, free trade
concept has not been abandoned since the case for free trade is strongest in the
long run. Protection is a short term measure. Thus, the issue for public policy is the
best reconciliation of these two perspectives so that gains from trade (may be free or
restricted) become the greatest.

Tariff and Non tariff barriers

Trade barriers are restrictions imposed on the movement of goods between
countries (import and export). The major purpose of trade barriers is to promote
domestic goods than exported goods, and there by safeguard the domestic
industries. Trade barriers can be broadly divided into tariff barriers and non tariff
barriers.

A tariff is a tax on imports or exports between sovereign states. It is a form of

regulation of foreign trade and a policy that taxes foreign products to encourage or
safeguard domestic industry. The tariff is historically used to protect infant
industries and to allow import substitution industrialization.

It includes:

 Term tariff means ‘Tax’ or ‘duty

 Tariff barriers are the ‘tax barriers’ or the ‘monetary barriers’
imposed on internationally traded goods when they cross the
national borders.

Major tariff barriers:

1. Specific duty: It is based on the physical characteristics of the good. A

fixed amount of money can be levied on each unit of imported goods
regardless of its price. Eg. Imposing of $15 on an imported shoe
2. Ad Valorem tariffs: The Latin phrase ‘ad valorem’ means “according to
the value”. This tax is flexible and depends upon the value or the price of
the commodity. Eg. Imposing tax of 5$ for a 50$ shoe and 10$ for a
100$ shoe.

3. Combined or compound duty: It is a combination of specific and ad

valorem duty on a single product, for instance , there can be a combined
duty when 10% of value(ad valorem) and 1$ per kilogram(specific tax)
are charged on metal M

4. Sliding scale duty: The duty which varies along with the price of the
commodity is known as sliding scale duty or seasonal duties. These
duties are confined to agricultural products, as their prices frequently
vary because of natural and other factors.

5. Countervailing duty: It is imposed on certain import where it is being

subsidised by exporting governments. As a result of the government
subsidy, imports become more cheaper than domestic goods, to nullify
the effect of subsidy, this duty is imposed in addition to normal duties.

6. Revenue tariff: A tariff which is designed to provide revenue or income

to the home government is known as revenue tariff. Generally this tariff
is imposed with a view of earning revenue by imposing duty on
consumer goods, particularly on luxury goods whose demand from the
rich is inelastic.

7. Anti –dumping duty: At times exporters attempt to capture foreign

markets by selling goods at rock-bottom prices, such practice is called
dumping. As a result of dumping, domestic industries find it difficult to
compete with imported goods. To offset anti-dumping effects, duties are
levied in addition to normal duties

8. Protective tariff: In order to protect domestic industries from stiff

competition of imported goods, protective tariff is levied on imports.
Normally a very high duty is imposed, so as to either discourage imports
or to make the imports more expensive as that of domestic products.

9. Classification of tariff on the basis of trade relationship: a) Single

column tariff: here the tariff rates are fixed for various commodities and
the same rates are charged for imports from all countries. Tariff rates are
uniform for all countries and discrimination between importing countries
is not made. b) Double column tariff: here two rates of tariff on all or
some commodities are fixed. The lower rate is made applicable to a
friendly country or the country with which bilateral trade agreement is
entered into. The higher rate is made with all other countries. c) Triple
column: here 3 rates are fixed. They are: general rate, international rate,
preferential rate. The first two are similar to lower and higher rates while
the preferential rate is substantially lower than the general rate and is
applicable to friendly countries with trade agreement or with close trade
relationship.
Non-tariff barriers to trade (NTBs) or sometimes called "Non-Tariff
Measures (NTMs)" are trade barriers that restrict imports or exports of goods or
services through mechanisms other than the simple imposition of tariffs.

It includes

 Any barriers other than tariff.

 It is meant for constructing barriers for the free flow of the goods.
 It do not affect the price of the imported goods.
 It affects the quality and quantity of the goods.

1. LICENSES: License is granted by the government, and allows the

importing of certain goods to the country.

2. VOLUNTARY EXPORT RESTRAINS(VER): These type of barriers

are created by the exporting country rather than the importing one.
These restrains are usually levied on the request of the importing
company. eg. Brazil can request Canada to impose VER on export of
sugar to brazil and this helps to increase the price of sugar in Brazil and
protects its domestic sugar producers.

3. Quotas: under this system, a country may fix in advance, the limit of
import quantity of commodity that would be permitted for import from
various countries during a given period. This is divided into the following
categories:
 Tariff quota: certain specified quantity of imports allowed at duty
free or at a reduced rate of import duty. A tariff quota, therefore,
combine the features of a tariff and import quota.

 unilateral quota: the total import quantity is fixed without prior

consultations with the exporting countries.
  bilateral quota: here quotas are fixed after negotiations between
the quota fixing importing country and the exporting country.

 multi lateral quota: a group of countries can come together and

fix quotas for each country.

4. Product standards: here the importing country imposes standards

for goods. If the standards are not met, the goods are rejected.

5. Domestic content requirements: governments impose DCR to

boost domestic production.

6. Product Labeling: certain countries insist on specific labeling of the

products. Eg. EU insist on products labeling in major languages in EU.

7. Packaging requirements: certain nations insist on particular type of

packaging of goods. Eg. EU insist on packaging with recyclable
materials.

8. Foreign exchange regulations: the importer has to ensure that

adequate foreign exchange is available for import of goods by obtaining
a clearance from exchange control authorities prior to the concluding of
contract with the supplier.

9. State trading: in some countries like India, certain items are imported
or exported only through canalising agencies like MMTT( minerals and
metals trading cooperation of India)

10. Embargo: partial or complete prohibition of trade with any particular

country, mainly because of the political tensions.

Other NTBs are: • Health and safety regulations. • Technical formalities

• Environment regulations

Difference between Tariff and Non-Tariff Barriers

1. With tariffs the Government receives the revenue whereas no revenue
is received by the Government by applying non-tariff measures.
However, it is favoured as an appropriate measure to meet the demand
of the country and to protect the industry.
2. Non-tariff measures protect the procedures and make them feel more
secure than under a tariff. But incentives are not there under tariffs.
3. In tariff customer’s classification and valuation procedures pose a
problem before the customs authorities. Where-as under non-tariff
measures no such problem arises.

4. Non-tariff barriers to trade induce the domestic producers to form

monopolistic organisations with a view to keeping output low and prices
high. This is not possible under import duty.

Non-tariff barriers remain ineffective if monopolistic tendencies prevail in

the country.

5. Non-tariff measures are flexible than tariff. Imposition of tariff and

amendments are subject to legislative enactment.

6. In non-tariff the price differences will be greater in two countries

because there is no free flow of imports; but in tariff—price differentiation
will be equal to the cost of tariff and transportation between exporting
and importing countries.

7. Tariffs are simple to operate. Tariff rates once fixed through legislation
require no individual allocation of licensing quotas or exchange.

For non-tariff measures numbers of authorities are there to administer. It

may result in political interference or corruption.

8. Tariff favours particularly to efficient firms in the country but non-tariff

measures benefit established firm because they get quotas or import
licenses.

9. Non-tariffs discriminate against new-comers but tariff do not

discriminate.