CENTRE FOR DISTANCE AND ONLINE EDUCATION,

AMU, ALIGARH

MASTER OF ARTS
IInd Semester

INTERNATIONAL ECONOMICS
(ECM-2003)

ALIGARH MUSLIM UNIVERSITY, ALIGARH, INDIA

 Syllabus
Unit-I: International Trade Theories
An Overview of Classical and Neo-Classical Theories of Trade, Mercantilism, Theory of
Comparative and Absolute Advantage, Porter’s National Competitive Advantage Theory, Factor
Endowments and the Heckscher-Ohlin Theory; Factor Price Equalisation Theorem; Leontiff
Paradox; Other Explanations for Trade: Availability and Vent for Surplus, Theory of
Overlapping Demand, Technological Gaps, Product Cycle Models; Intra- Industry Trade and its
Measurement.
Unit-II: Balance of Payment and Trade Protection
Balance of Payments and Trade Policy Equilibrium and Disequilibrium in the Balance of
Payments; Elasticity, Absorption, Monetary and Portfolio-Balance Approach to Balance of
Payments Adjustment, Macroeconomic Model under Alternative Exchange Rate Regimes,
Combining Exchange Rate Adjustments and Fiscal Policy: Salter-Swan Model; Crypto
Currency: Meaning, Nature, Relevance and Effects. Tariff and Non-Tariff Instruments of Trade
Policy, Comparison of Tariff and Quota. Nominal and Effective Rate of Protection. Effects of
Tariff for Small and Large Countries.
Unit-III: International Trading Organisations and Global Trading System
World Trade and Theory of Regional Blocks, GATT and Trade Rounds, Multilateral Trading
System and the World Trade Organization (WTO) – TRIMS, International Trade in Services and
GATS, TRIPS, Trade and Environment, Trade and Labour Standards, Theory of Custom Union,
Static and Dynamic Effects of a Customs Union and Free Trade Areas; Rationale and Economic
Progress of European Union SAARC/SAPTA and ASEAN.

Readings:
Salvatore, D. (1997), International Economics, Prentice Hall, Upper Saddle River, N.J., New
York. Soderston, B.O. (1994), International Economics, The Macmillan Press Ltd., London.
Chacholiades, M. (1990), International Trade: Theory and Policy, McGraw Hill, Kogakusha,
Japan. Kenen, P.B. (1994), The International Economy, Cambridge University Press, London.
Kindlberger, C.P. (1973), International Economics, R.D. Irwin, Homewood.
Krugman, P.R. and M. Obstgeld (1994), International Economics: Theory and Policy, Glenview,
Foresman.
Yeager, L.B. (1976), International Monetary Relations: Theory, History and Policy, Harper and
Row, New York.
Solomon, R. (1982), The International monetary System, 1945-81, Harper and Row, New York.
Tew, B. (1985), The Evolution of the International Monetary System: 1945 – 85, Hutchinson.
Aggarwal,
M.R. (1979), Regional Economic Cooperation in South Asia, S. Chand and Co., New Delhi.
Kenen, P.B. (1995), Economic and Monetary Union in Europe, Cambridge University Press,
Caves, Jones and Frankel (1999), World Trade and Payments, 8th Edition, Addison-Wesley.
 CONTENTS
Unit-I International Trade Theories
Structure
1.0. Unit Objective
1.1. Introduction
1.2. Neo-Classical Economics
1.3. Different International Trade Theories
1.4. Classical Trade Theories
1.5. Porter’s National Competitive Advantage Theory
1.6. Intra-Industry Trade and Its Measurement
1.7. Summary
1.8. Check Your Progress
1.8. References
Unit-II Balance of Payment and Trade Protection
Structure
2.0. Unit Objectives
2.1. Introduction
2.2. Equilibrium, Disequilibrium and Adjustment in the Balance of Payments
2.3. Correcting Disequilibrium in the Balance of Payments
2.4. Approaches of Balance of Payments
2.5. Criticisms of Elasticity Approach
2.6. Criticisms of Absorption Approach
2.7. Criticisms of Monetary Approach
2.8. Crypto Currency: Meaning, Nature, Relevance and Effects
2.9. Tariff and Non-Tariff Instruments of Trade Policy
2.10. Non-Tariff Instruments of Trade Policy
2.11. Comparison of Tariff and Quota
2.12. Nominal and Effective Rate of Protection
2.13. Summary
2.14. Check Your Progress
Unit-III International Trading Organisations and Global Trading System
Structure
3.0 Introduction
3.1 Unit Objective
3.2 World Trade and Theory of Regional Blocks
3.3 GATT and Trade Rounds,
3.4 Multilateral Trading System and the World Trade Organization (WTO) –
3.5 Trade and Environment,
3.6 Trade and Labor Standards
3.7 Theory of Custom Union
3.8 Static and Dynamic Effects of a Customs Union and Free Trade Areas;
3.9 Rationale and Economic Progress of
3.10 Summary
3.11 Answer to Check Your Progress
3.12 Questions and Exercises
 Unit-I
International Trade Theories
Structure
1.0. Unit Objective
1.1. Introduction
1.2. Neo-Classical Economics
1.3. Different International Trade Theories
1.4. Classical Trade Theories
1.5. Porter’s National Competitive Advantage Theory
1.6. Intra-Industry Trade and Its Measurement
1.7. Summary
1.7. Check Your Progress
1.8. References
---------------------------------------------------------------------------------------------------------------------
1.0. Unit Objectives
1. Understand international trade.
2. Compare and contrast different trade theories.
3. Determine which international trade theory is most relevant today and how it continues to
evolve.
1.1. Introduction
International trade theories are simply different theories to explain international trade.
Trade is the concept of exchanging goods and services between two people or
entities. International trade is then the concept of this exchange between people or entities in
two different countries.
People or entities trade because they believe that they benefit from the exchange. They may need
or want the goods or services. While at the surface, this many sound very simple, there is a great
deal of theory, policy, and business strategy that constitutes international trade.
1.2. Neo-classical Economics
Neoclassical economics is a broad theory that focuses on supply and demand as the
driving forces behind the production, pricing, and consumption of goods and services. It emerged
in around 1900 to compete with the earlier theories of classical economics.
The neoclassical model of trade argues that the production possibilities curve is convex, or that
the opportunity cost of producing a good increases as production of the goods increase. This
view differs from the Ricardian Model, which assumes constant opportunity costs and a linear
production possibilities curve. The neoclassical model proposes that as countries specialize and
develop comparative advantage at producing one good or another, the opportunity costs will
increase or decrease in at exponential rates. This is because a country’s decision to produce, for
instance, fewer of one good in which it has comparative and instead produce another in which is
has less skill will cause increasingly large opportunity costs; although the initial resources used
to begin producing the new good would be those with the most comparative advantage at
producing that good (whether raw materials, technology, human capital, etc), continued
production would necessitate the use of less efficient resources that could, theoretically, best be
used in the production of the first good in which the country has more of a comparative
advantage.
In next section, you’ll learn about the different trade theories that have evolved over the
past century and which are most relevant today. Additionally, you’ll explore the factors that
impact international trade and how businesses and governments use these factors to their
respective benefits to promote their interests.
1.3. Different International Trade Theories
Around 5,200 years ago, Uruk, in southern Mesopotamia, was probably the first city the
world had ever seen, housing more than 50,000 people within its six miles of wall. Uruk, its
agriculture made prosperous by sophisticated irrigation canals, was home to the first class of
middlemen, trade intermediaries.
To better understand how modern global trade has evolved, it’s important to understand
how countries traded with one another historically. Over time, economists have developed
theories to explain the mechanisms of global trade. The main historical theories are
called classical and are from the perspective of a country, or country-based. By the mid-
twentieth century, the theories began to shift to explain trade from a firm, rather than a country,
perspective. These theories are referred to as modern and are firm-based or company-based. Both
of these categories, classical and modern, consist of several international theories.
1.4. Classical Trade Theories
Mercantilism
Developed in the sixteenth century, mercantilism was one of the earliest efforts to develop an
economic theory. This theory stated that a country’s wealth was determined by the amount of its
gold and silver holdings. In it’s simplest sense, mercantilists believed that a country should
increase its holdings of gold and silver by promoting exports and discouraging imports. In other
words, if people in other countries buy more from you (exports) than they sell to you (imports),
then they have to pay you the difference in gold and silver. The objective of each country was to
have a trade surplus, or a situation where the value of exports are greater than the value of
imports, and to avoid a trade deficit, or a situation where the value of imports is greater than the
value of exports.
A closer look at world history from the 1500s to the late 1800s helps explain why mercantilism
flourished. The 1500s marked the rise of new nation-states, whose rulers wanted to strengthen
their nations by building larger armies and national institutions. By increasing exports and trade,
these rulers were able to amass more gold and wealth for their countries. One way that many of
these new nations promoted exports was to impose restrictions on imports. This strategy is
called protectionism and is still used today.
Nations expanded their wealth by using their colonies around the world in an effort to control
more trade and amass more riches. The British colonial empire was one of the more successful
examples; it sought to increase its wealth by using raw materials from places ranging from what
are now the Americas and India. France, the Netherlands, Portugal, and Spain were also
successful in building large colonial empires that generated extensive wealth for their governing
nations.
Although mercantilism is one of the oldest trade theories, it remains part of modern thinking.
Countries such as Japan, China, Singapore, Taiwan, and even Germany still favor exports and
discourage imports through a form of neo-mercantilism in which the countries promote a
combination of protectionist policies and restrictions and domestic-industry subsidies. Nearly
every country, at one point or another, has implemented some form of protectionist policy to
guard key industries in its economy. While export-oriented companies usually support
protectionist policies that favor their industries or firms, other companies and consumers are hurt
by protectionism. Taxpayers pay for government subsidies of select exports in the form of higher
taxes. Import restrictions lead to higher prices for consumers, who pay more for foreign-made
goods or services. Free-trade advocates highlight how free trade benefits all members of the
global community, while mercantilism’s protectionist policies only benefit select industries, at
the expense of both consumers and other companies, within and outside of the industry.
Theory of Absolute Advantage
In 1776, Adam Smith questioned the leading mercantile theory of the time in The Wealth of
Nations. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations. Recent
versions have been edited by scholars and economists. Smith offered a new trade theory
called absolute advantage, which focused on the ability of a country to produce a good more
efficiently than another nation. Smith reasoned that trade between countries shouldn’t be
regulated or restricted by government policy or intervention. He stated that trade should flow
naturally according to market forces. In a hypothetical two-country world, if Country A could
produce a good cheaper or faster (or both) than Country B, then Country A had the advantage
and could focus on specializing on producing that good. Similarly, if Country B was better at
producing another good, it could focus on specialization as well. By specialization, countries
would generate efficiencies, because their labor force would become more skilled by doing the
same tasks. Production would also become more efficient, because there would be an incentive
to create faster and better production methods to increase the specialization.
Smith’s theory reasoned that with increased efficiencies, people in both countries would benefit
and trade should be encouraged. His theory stated that a nation’s wealth shouldn’t be judged by
how much gold and silver it had but rather by the living standards of its people.
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 laborers. Country A uses 10
laborers to produce 1 ton of tea and 20 laborers to produce 1 ton of coffee. Country B uses 25
units of laborers to produce tea and 5 units of laborers to produce 1 ton of coffee.
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 labor 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 labor
as the only factor of production. Now assume that both the countries have 200 laborers and they
use 100 laborers to produce wheat and 100 laborers to produce wine.
The challenge to the absolute advantage theory was that some countries may be better at
producing both goods and, therefore, have an advantage in many areas. In contrast, another
country may not have any useful absolute advantages. To answer this challenge, David Ricardo,
an English economist, introduced the theory of comparative advantage in 1817. Ricardo reasoned
that even if Country A had the absolute advantage in the production of both products,
specialization and trade could still occur between two countries.
Comparative advantage occurs when a country cannot produce a product more efficiently than
the other country; however, it can produce that product better and more efficiently than it does
other goods. The difference between these two theories is subtle. Comparative advantage focuses
on the relative productivity differences, whereas absolute advantage looks at the absolute
productivity.
Let’s look at a simplified hypothetical example to illustrate the subtle difference between these
principles. Miranda is a Wall Street lawyer who charges $500 per hour for her legal services. It
turns out that Miranda can also type faster than the administrative assistants in her office, who
are paid $40 per hour. Even though Miranda clearly has the absolute advantage in both skill sets,
should she do both jobs? No. For every hour Miranda decides to type instead of do legal work,
she would be giving up $460 in income. Her productivity and income will be highest if she
specializes in the higher-paid legal services and hires the most qualified administrative assistant,
who can type fast, although a little slower than Miranda. By having both Miranda and her
assistant concentrate on their respective tasks, their overall productivity as a team is higher. This
is comparative advantage. A person or a country will specialize in doing what they
do relatively better. In reality, the world economy is more complex and consists of more than
two countries and products. Barriers to trade may exist, and goods must be transported, stored,
and distributed. However, this simplistic example demonstrates the basis of the comparative
advantage theory.
Heckscher-Ohlin Theory (Factor Proportions Theory)
The theories of Smith and Ricardo didn’t help countries determine which products would give a
country an advantage. Both theories assumed that free and open markets would lead countries
and producers to determine which goods they could produce more efficiently. In the early 1900s,
two Swedish economists, Eli Heckscher and Bertil Ohlin, focused their attention on how a
country could gain comparative advantage by producing products that utilized factors that were
in abundance in the country. Their theory is based on a country’s production factors—land,
labor, and capital, which provide the funds for investment in plants and equipment. They
determined that the cost of any factor or resource was a function of supply and demand. Factors
that were in great supply relative to demand would be cheaper; factors in great demand relative
to supply would be more expensive. Their theory, also called the factor proportions theory, stated
that countries would produce and export goods that required resources or factors that were in
great supply and, therefore, cheaper production factors. In contrast, countries would import
goods that required resources that were in short supply, but higher demand.
For example, China and India are home to cheap, large pools of labor. Hence these countries
have become the optimal locations for labor-intensive industries like textiles and garments.

Leontief Paradox
In the early 1950s, Russian-born American economist Wassily W. Leontief studied the US
economy closely and noted that the United States was abundant in capital and, therefore, should
export more capital-intensive goods. However, his research using actual data showed the
opposite: the United States was importing more capital-intensive goods. According to the factor
proportions theory, the United States should have been importing labor-intensive goods, but
instead it was actually exporting them. His analysis became known as the Leontief
Paradox because it was the reverse of what was expected by the factor proportions theory. In
subsequent years, economists have noted historically at that point in time, labor in the United
States was both available in steady supply and more productive than in many other countries;
hence it made sense to export labor-intensive goods. Over the decades, many economists have
used theories and data to explain and minimize the impact of the paradox. However, what
remains clear is that international trade is complex and is impacted by numerous and often-
changing factors. Trade cannot be explained neatly by one single theory, and more importantly,
our understanding of international trade theories continues to evolve.
Country Similarity Theory
Swedish economist Steffan Linder developed the country similarity theory in 1961, as he tried to
explain the concept of intra industry trade. Linder’s theory proposed that consumers in countries
that are in the same or similar stage of development would have similar preferences. In this firm-
based theory, Linder suggested that companies first produce for domestic consumption. When
they explore exporting, the companies often find that markets that look similar to their domestic
one, in terms of customer preferences, offer the most potential for success. Linder’s country
similarity theory then states that most trade in manufactured goods will be between countries
with similar per capita incomes, and intraindustry trade will be common. This theory is often
most useful in understanding trade in goods where brand names and product reputations are
important factors in the buyers’ decision-making and purchasing processes.
Product Life Cycle Theory
Raymond Vernon, a Harvard Business School professor, developed the product life cycle
theory in the 1960s. The theory, originating in the field of marketing, stated that a product life
cycle has three distinct stages: (1) new product, (2) maturing product, and (3) standardized
product. The theory assumed that production of the new product will occur completely in the
home country of its innovation. In the 1960s this was a useful theory to explain the
manufacturing success of the United States. US manufacturing was the globally dominant
producer in many industries after World War II.
It has also been used to describe how the personal computer (PC) went through its product cycle.
The PC was a new product in the 1970s and developed into a mature product during the 1980s
and 1990s. Today, the PC is in the standardized product stage, and the majority of manufacturing
and production process is done in low-cost countries in Asia and Mexico.
The product life cycle theory has been less able to explain current trade patterns where
innovation and manufacturing occur around the world. For example, global companies even
conduct research and development in developing markets where highly skilled labor and
facilities are usually cheaper. Even though research and development is typically associated with
the first or new product stage and therefore completed in the home country, these developing or
emerging-market countries, such as India and China, offer both highly skilled labor and new
research facilities at a substantial cost advantage for global firms.
Global Strategic Rivalry Theory
Global strategic rivalry theory emerged in the 1980s and was based on the work of economists
Paul Krugman and Kelvin Lancaster. Their theory focused on MNCs and their efforts to gain a
competitive advantage against other global firms in their industry. Firms will encounter global
competition in their industries and in order to prosper, they must develop competitive
advantages. The critical ways that firms can obtain a sustainable competitive advantage are
called the barriers to entry for that industry. The barriers to entry refer to the obstacles a new
firm may face when trying to enter into an industry or new market. The barriers to entry that
corporations may seek to optimize include:
 research and development,
 the ownership of intellectual property rights,
 economies of scale,
 unique business processes or methods as well as extensive experience in the industry, and
  the control of resources or favorable access to raw materials.
1.5. Porter’s National Competitive Advantage Theory
In the continuing evolution of international trade theories, Michael Porter of Harvard Business
School developed a new model to explain national competitive advantage in 1990. Porter’s
theory stated that a nation’s competitiveness in an industry depends on the capacity of the
industry to innovate and upgrade. His theory focused on explaining why some nations are more
competitive in certain industries. To explain his theory, Porter identified four determinants that
he linked together. The four determinants are (1) local market resources and capabilities, (2)
local market demand conditions, (3) local suppliers and complementary industries, and (4) local
firm characteristics.
1. Local market resources and capabilities (factor conditions). Porter recognized the
value of the factor proportions theory, which considers a nation’s resources (e.g., natural
resources and available labor) as key factors in determining what products a country will
import or export. Porter added to these basic factors a new list of advanced factors, which
he defined as skilled labor, investments in education, technology, and infrastructure. He
perceived these advanced factors as providing a country with a sustainable competitive
advantage.
2. Local market demand conditions. Porter believed that a sophisticated home market is
critical to ensuring ongoing innovation, thereby creating a sustainable competitive
advantage. Companies whose domestic markets are sophisticated, trendsetting, and
demanding forces continuous innovation and the development of new products and
technologies. Many sources credit the demanding US consumer with forcing US software
companies to continuously innovate, thus creating a sustainable competitive advantage in
software products and services.
3. Local suppliers and complementary industries. To remain competitive, large global
firms benefit from having strong, efficient supporting and related industries to provide
the inputs required by the industry. Certain industries cluster geographically, which
provides efficiencies and productivity.
4. Local firm characteristics. Local firm characteristics include firm strategy, industry
structure, and industry rivalry. Local strategy affects a firm’s competitiveness. A healthy
level of rivalry between local firms will spur innovation and competitiveness.
In addition to the four determinants of the diamond, Porter also noted that government and
chance play a part in the national competitiveness of industries. Governments can, by their
actions and policies, increase the competitiveness of firms and occasionally entire industries.
Porter’s theory, along with the other modern, firm-based theories, offers an interesting
interpretation of international trade trends. Nevertheless, they remain relatively new and
minimally tested theories.
Which Trade Theory is Dominant Today?
The theories covered in this chapter are simply that—theories. While they have helped
economists, governments, and businesses better understand international trade and how to
promote, regulate, and manage it, these theories are occasionally contradicted by real-world
events. Countries don’t have absolute advantages in many areas of production or services and, in
fact, the factors of production aren’t neatly distributed between countries. Some countries have a
disproportionate benefit of some factors. The United States has ample arable land that can be
used for a wide range of agricultural products. It also has extensive access to capital. While it’s
labor pool may not be the cheapest, it is among the best educated in the world. These advantages
in the factors of production have helped the United States become the largest and richest
economy in the world. Nevertheless, the United States also imports a vast amount of goods and
services, as US consumers use their wealth to purchase what they need and want—much of
which is now manufactured in other countries that have sought to create their own comparative
advantages through cheap labor, land, or production costs.
As a result, it’s not clear that any one theory is dominant around the world. This section has
sought to highlight the basics of international trade theory to enable you to understand the
realities that face global businesses. In practice, governments and companies use a combination
of these theories to both interpret trends and develop strategy. Just as these theories have evolved
over the past five hundred years, they will continue to change and adapt as new factors impact
international trade.
1.6. Intra-Industry Trade and Its Measurement
Absolute and comparative advantages explain a great deal about patterns of global trade. For
example, they help to explain the patterns noted at the start of this chapter, like why you may be
eating fresh fruit from Chile or Mexico, or why lower productivity regions like Africa and Latin
America are able to sell a substantial proportion of their exports to higher productivity regions
like the European Union and North America. Comparative advantage, however, at least at first
glance, does not seem especially well-suited to explain other common patterns of international
trade.
The Prevalence of Intra-Industry Trade between Similar Economies
The theory of comparative advantage suggests that trade should happen between economies with
large differences in opportunity costs of production. Roughly half of all world trade involves
shipping goods between the fairly similar high-income economies of the United States, Canada,
the European Union, Japan, Mexico, and China.
Country U.S. Exports Go to … U.S. Imports Come from …
European Union 19.0% 21.0%
Canada 22.0% 14.0%
Japan 4.0% 6.0%
Mexico 15.0% 13.0%
China 8.0% 20.0%
Table 14. Where U.S. Exports Go and U.S. Imports Originate (2015)
(Source: https://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf)
Moreover, the theory of comparative advantage suggests that each economy should
specialize to a degree in certain products, and then exchange those products. A high proportion
of trade, however, is intra-industry trade—that is, trade of goods within the same industry from
one country to another. For example, the United States produces and exports autos and imports
autos. Table 15 shows some of the largest categories of U.S. exports and imports. In all of these
categories, the United States is both a substantial exporter and a substantial importer of goods
from the same industry. In 2014, according to the Bureau of Economic Analysis, the United
States exported $159 billion worth of autos, and imported $327 billion worth of autos. About
60% of U.S. trade and 60% of European trade is intra-industry trade.
Some U.S. Exports Quantity of Exports ($ billions) Quantity of Imports ($ billions)
Autos $146 $327
Food and beverages $144 $126
Capital goods $550 $551
Consumer goods $199 $558
Some U.S. Exports Quantity of Exports ($ billions) Quantity of Imports ($ billions)
Industrial supplies $507 $665
Other transportation $45 $55
Table 15. Some Intra-Industry U.S. Exports and Imports in 2014
(Source: http://www.bea.gov/newsreleases/international/trade/tradnewsrelease.htm)
Why do similar high-income economies engage in intra-industry trade? What can be the
economic benefit of having workers of fairly similar skills making cars, computers, machinery
and other products which are then shipped across the oceans to and from the United States, the
European Union, and Japan? There are two reasons:
(1) The division of labor leads to learning, innovation, and unique skills; and
(2) Economies of scale.
Gains from Specialization and Learning
Consider the category of machinery, where the U.S. economy has considerable intra-industry
trade. Machinery comes in many varieties, so the United States may be exporting machinery for
manufacturing with wood, but importing machinery for photographic processing. The underlying
reason why a country like the United States, Japan, or Germany produces one kind of machinery
rather than another is usually not related to U.S., German, or Japanese firms and workers having
generally higher or lower skills. It is just that, in working on very specific and particular
products, firms in certain countries develop unique and different skills.
Specialization in the world economy can be very finely split. In fact, recent years have seen a
trend in international trade called splitting up the value chain. The value chain describes how a
good is produced in stages. As indicated in the beginning of the chapter, the production of the
iPhone involves the design and engineering of the phone in the United States, parts supplied
from Korea, the assembly of the parts in China, and the advertising and marketing done in the
United States. Thanks in large part to improvements in communication technology, sharing
information, and transportation, it has become easier to split up the value chain. Instead of
production in a single large factory, all of these steps can be split up among different firms
operating in different places and even different countries. Because firms split up the value chain,
international trade often does not involve whole finished products like automobiles or
refrigerators being traded between nations. Instead, it involves shipping more specialized goods
like, say, automobile dashboards or the shelving that fits inside refrigerators. Intra-industry trade
between similar countries produces economic gains because it allows workers and firms to learn
and innovate on particular products—and often to focus on very particular parts of the value
chain.
Economies of Scale, Competition, Variety
A second broad reason that intra-industry trade between similar nations produces economic gains
involves economies of scale. The concept of economies of scale, as introduced in Cost and
Industry Structure, means that as the scale of output goes up, average costs of production
decline—at least up to a point. Figure 1 illustrates economies of scale for a plant producing
toaster ovens. The horizontal axis of the figure shows the quantity of production by a certain firm
or at a certain manufacturing plant. The vertical axis measures the average cost of production.
Production plant S produces a small level of output at 30 units and has an average cost of
production of $30 per toaster oven. Plant M produces at a medium level of output at 50 units, and
has an average cost of production of $20 per toaster oven. Plant L produces 150 units of output
with an average cost of production of only $10 per toaster oven. Although plant V can produce
200 units of output, it still has the same unit cost as Plant L.
In this example, a small or medium plant, like S or M, will not be able to compete in the market
with a large or a very large plant like L or V, because the firm that operates L or V will be able to
produce and sell their output at a lower price. In this example, economies of scale operate up to
point L, but beyond point L to V, the additional scale of production does not continue to reduce
average costs of production.

Figure 1.
Economies of Scale. Production Plant S, has an average cost of production of $30 per toaster
oven. Production plant M has an average cost of production of $20 per toaster oven. Production
plant L has an average cost of production of only $10 per toaster oven. Production plant V would
still have an average cost of production of $10 per toaster oven. Thus, production plant M can
produce toaster ovens more cheaply than plant S because of economies of scale, and plants L or
V can produce more cheaply than S or M because of economies of scale. However, the
economies of scale end at an output level of 150. Plant V, despite being larger, cannot produce
more cheaply on average than plant L.
The concept of economies of scale becomes especially relevant to international trade when it
enables one or two large producers to supply the entire country. For example, a single large
automobile factory could probably supply all the cars purchased in a smaller economy like the
United Kingdom or Belgium in a given year. However, if a country has only one or two large
factories producing cars, and no international trade, then consumers in that country would have
relatively little choice between kinds of cars (other than the color of the paint and other
nonessential options). Little or no competition will exist between different car manufacturers.
International trade provides a way to combine the lower average production costs that come from
economies of scale and still have competition and variety for consumers. Large automobile
factories in different countries can make and sell their products around the world. If the U.S.
automobile market was made up of only General Motors, Ford, and Chrysler, the level of
competition and consumer choice would be quite a lot lower than when U.S. carmakers must
face competition from Toyota, Honda, Suzuki, Fiat, Mitsubishi, Nissan, Volkswagen, Kia,
Hyundai, BMW, Subaru, and others. Greater competition brings with it innovation and
responsiveness to what consumers want. America’s car producers make far better cars now than
they did several decades ago, and much of the reason is competitive pressure, especially from
East Asian and European carmakers.
Dynamic Comparative Advantage
The sources of gains from intra-industry trade between similar economies—namely, the learning
that comes from a high degree of specialization and splitting up the value chain and from
economies of scale do not contradict the earlier theory of comparative advantage. Instead, they
help to broaden the concept.
In intra-industry trade, the level of worker productivity is not determined by climate or
geography. It is not even determined by the general level of education or skill. Instead, the level
of worker productivity is determined by how firms engage in specific learning about specialized
products, including taking advantage of economies of scale. In this vision, comparative
advantage can be dynamic—that is, it can evolve and change over time as new skills are
developed and as the value chain is split up in new ways. This line of thinking also suggests that
countries are not destined to have the same comparative advantage forever, but must instead be
flexible in response to ongoing changes in comparative advantage.
1.7. Summary
A large share of global trade happens between high-income economies that are quite similar in
having well-educated workers and advanced technology. These countries practice intra-industry
trade, in which they import and export the same products at the same time, like cars, machinery,
and computers. In the case of intra-industry trade between economies with similar income levels,
the gains from trade come from specialized learning in very particular tasks and from economies
of scale. Splitting up the value chain means that several stages of producing a good take place in
different countries around the world.
1.8. Check Your Progress
1. What is intra-industry trade?
2. What are the two main sources of economic gains from intra-industry trade?
3. What is splitting up the value chain?
4. Does intra-industry trade contradict the theory of comparative advantage?
5. Do consumers benefit from intra-industry trade?
6. Why might intra-industry trade seem surprising from the point of view of
comparative advantage?
1.9. References
Salvatore, D. (1997), International Economics, Prentice Hall, Upper Saddle River, N.J., New York.
Soderston, B.O. (1994), International Economics, The Macmillan Press Ltd., London.
Chacholiades, M. (1990), International Trade: Theory and Policy, McGraw Hill, Kogakusha,
Japan. Kenen, P.B. (1994), The International Economy, Cambridge University Press, London.
Kindlberger, C.P. (1973), International Economics, R.D. Irwin, Homewood.
 Unit-II
Balance of Payment and Trade Protection
Structure
2.0. Unit Objectives
2.1. Introduction
2.2. Equilibrium, Disequilibrium and Adjustment in the Balance of Payments
2.3. Correcting Disequilibrium in the Balance of Payments
2.4. Approaches of Balance of Payments
2.5. Criticisms of Elasticity Approach
2.6. Criticisms of Absorption Approach
2.7. Criticisms of Monetary Approach
2.8. Crypto Currency: Meaning, Nature, Relevance and Effects
2.9. Tariff and Non-Tariff Instruments of Trade Policy
2.10. Non-Tariff Instruments of Trade Policy
2.11. Comparison of Tariff and Quota
2.12. Nominal and Effective Rate of Protection
2.13. Summary
2.14. Check Your Progress
---------------------------------------------------------------------------------------------------------------------
2.0. Unit Objectives
1. Understand Balance of Payment.
2. You should learn about Equilibrium and Disequilibrium in balance of Payment.
2.1. Introduction
India generally experiences a huge deficit of the balance of payment due to its size. This is all
down to the fact that India requires imported technology, machines, and other resources to run its
economy successfully. To know about a country’s economic stability and sustainability, the
balance of payment is the measure. Thus, it is usually accountable for 1 year. Also, these
payments and receipts include outflows and inflows like payments and receipts. So, in terms of
the balance of payment, there is a surplus balance of payment and balance of payment deficit.
The concept of balance of payments in the sense of basic balance can be represented by the
following equation:
(X-M) + LTC = 0
Where X stands for exports including invisible items.
M stands for imports including invisible items.
LTC stands for long-term capital movements.
If (X- M) is positive (i.e., X > M), then for balance of payments to be in equilibrium, LTC will
be negative and equal to (X- M). This implies that there will be net capital outflow. On the other
hand, if M > X, then for the balance of payments to be in equilibrium LTC must be positive (that
is, there will be net capital inflow to offset the deficit in the current account).
When the balance of payments of a country is in equilibrium, the demand for the domestic
currency is equal to its supply. The demand and supply situation is thus neither favorable nor
unfavorable. If the balance of payments moves against a country, adjustments must be made by
encouraging exports of goods, services or other forms of exports, or by discouraging imports of
all kinds. No country can have a permanently unfavorable balance of payments. Total liabilities
and total assets of nations, as of individuals, must balance in the long run.
This does not mean that the balance of payments of a country should be in equilibrium indi-
vidually with every other country with which she has trade relations. This is not necessary, nor is
it the case in the real world. Trade relations are multilateral.
India, for instance, may have balance of payments deficit with the United States and surplus with
the United Kingdom and/or other countries, but each country, in the long run, cannot receive
more value than she has exported to other countries taken together.
Equilibrium in the balance of payments, therefore, is a sign of the soundness of a country’s
economy. But disequilibrium may arise either for short or for long periods. A continued
disequilibrium indicates that the country is heading towards economic and financial bankruptcy.
Every country, therefore, must try to maintain balance of payments in equilibrium. To know how
this can be done involves the study of the causes of disequilibrium.
2.3. Significant of Balance of Payment (BoP)
In terms of the balance of payment, a country has to take care of three types of items. Visible
items include various types of physical goods that are imported and exported. While invisible
items include all the services whose import and export are not visible.
This includes medical services, transport services, etc. The third one is a capital transfer which is
concerned with capital payments and capital receipts. A country can acquire these goods only by
accommodating a capital deficit and this deficit is called the balance of payment.
BoP can be broken down into the balance of trade, the balance of current account, and capital
account. The balance of trade includes exports and imports. The balance of the current account
includes the balances of service and remittance, the balance of trade, etc.
While the capital account is mainly investing and borrowing. The capital account of any country
includes transactions in terms of financial assets for the long term as well as short term
borrowing and lending. The current account is also known as the balance of trade.
This includes private transfer payments like gifts, grants, remittances, etc. It also includes
nonfactor trade services like banking software, shipping, etc. While capital account includes
commercial borrowings, foreign investment, other flows, rupee debt services, etc.
Important Terms Used
Remittances
In recent times, in comparison to dollars, rupees has weakened considerably. Thus, it is expected
that there will be a rise in remittances as the NRIs take advantage of buying cheaper goods,
assets, and services back home in India. The controls on the money are lifted and thus there are
greater inflows.
Also, the government has reduced the red tape that is excessive documents required for the
process. Furthermore, the interest rates are also high and RBI has increased the amount due to
which more amount can be remitted back home.
2.2. Equilibrium, Disequilibrium and Adjustment in the Balance of Payments
When the demand and supply of any foreign currency in a country in a given time period is
equal, it is termed as ‘Equilibrium position’ in the balance of payment. While a disequilibrium
means that the condition is either deficit or surplus.
The surplus in the balance of payment occurs when the total payments are exceeded by the total
receipts. Similarly, a deficit occurs when the total receipts are exceeded by total payments.
Balance of Payments Equilibrium
Before we analyse the conditions of disequilibrium, we would like to explain what is meant by
equilibrium balance of payments.
“Equilibrium is that state of the balance of payments over the relevant time period which makes
it possible to sustain an open economy without severe unemployment on a continuing basis”.
The essentials in this definition are
(a) Relevant time period,
(b) Open-ness of economy (i.e., no undue restrictions on imports),
(c) Absence of unemployment, and
(d) Continuing basis of the equilibrium (i.e.; it is capable of being sustained).
The period is generally one year. Thus, seasonal inequality between exports and imports is not a
sign of disequilibrium. When the balance of payments of a country is in equilibrium, the demand
for domestic currency is equal to its supply.
The demand and supply situation is thus neither favourable nor unfavorable. If the balance of
payments moves against a country, adjustments must be made by encouraging exports of goods,
services or other forms of exports, or by discouraging imports of all kinds. No country can have
a permanently unfavorable balance of payments, though it is possible—and is quite common for
some countries—to have a permanently un-favourable balance of trade. Total liabilities and total
assets of nations, as of individuals, must balance in the long run.
This does not mean that the balance of payment of a country should be in equilibrium
individually with every other country with which she has trade relations. This is not necessary
nor is it the case in the real world. Trade relations are multilateral. India, for instance, may have
an active (i.e. surplus) balance of payments with the United States and passive balance with the
United Kingdom and/or other countries. But each country, in the long run, cannot receive more
value than she has exported to other countries taken together.
Equilibrium in the balance of payments, therefore, is a sign of the soundness of a country’s
economy. But disequilibrium may arise either for short or long periods. A continued
disequilibrium indicates that the country is heading towards economic and financial bankruptcy.
Every country, therefore, must try to maintain balance of payments in equilibrium.
2.3. Correcting Disequilibrium in the Balance of Payments
The balance of payments 01 India for 1982-83 gives above shows a heavily adverse balance of
payments on current account. When the visible and invisible exports of a country are less than all
her imports (or the imports exceed the exports) over a long period and the difference is big, steps
have to be taken to bridge the gap. A number of methods are used.
 Improving the balance of trade through import restrictions and measures of export
promotion. Since balance of payments becomes adverse chiefly on account of excess of imports
over exports, the most urgent steps are to be taken in this direction. A country having an adverse
balance of payments must to check imports, or to stimulate exports, or do both. Imports can be
checked either by total prohibition, or by levying import duties, or by a quota system.
Another method is adopting of measures of import substitutions, i.e., trying to produce in the
country what it currently imports from abroad. Exports can be stimulated by measures of export
promotion i.e. granting bounties or other concessions to industrialists and exporters.
Deflation
Another method is deflation. Under this method, total money income in the economy is sought to
be reduced, so that the aggregate demand in the country falls. As a result, the people tend to
import less and their demand for home-produced goods too becomes less, releasing more of them
for exports.
Owing to a fall in aggregate demand, prices also fall, so that the country becomes a good market
to buy from and a bad market to sell in. In this way, imports get discouraged and exports are
stimulated, thus correcting the adverse balance of payments. But deflation is not a healthy
method, because the reduction of money incomes hits business, trade and industry hard and
brings about depression and unemployment.
Exchange Control
Sometimes the adoption of any of the above methods is not “considered desirable. It is feared
that the depreciation may lead to retaliatory depreciation by other countries. Devaluation is
supposed to damage the prestige of a country. Deflation brings in its wake disastrous
consequences in the form of depression and widespread unemployment.
It may, therefore, be considered necessary to avoid these methods and instead exchange control
adopted. Under a system of exchange Control all exporters are asked to surrender their claims on
foreign currencies to the central bank which pays in return home currency, which the exporters
really want.
This available foreign exchange is rationed out by the central bank among me needed importers
of the essential commodities. Thus, imports are restricted to the foreign exchange available.
There is no danger of more goods being imported than exported.
Devaluation
A very common method of correcting an adverse balance of payments is the devaluation of the
home currency. The devalued currency falls in value against foreign currencies so that the
foreigners have to pay less in terms of their own currencies for our goods.
The importers in the country, on the other hand, have now to pay more in terms of the devalued
currency for foreign goods. Hence, they (i.e., foreigners) are induced to import more from such a
country. Thus her imports decrease and exports increase, and the balance of payments is
corrected. For example, India, following the U.K., devalued her currency in terms of the dollar in
September 1949. Her trade balance had been very unfavorable.
There used to be a big gap between her exports and imports. After the devaluation, however, her
balance of payments was set right. In June 1966, again, India had to devalue the rupee. This
resulted in some improvement in the balance of payments position.
The success of devaluation in improving the balance of trade, and through it the balance of
payments depends upon the demand elasticity’s of imports and exports of the devaluing country.
In other words, an improvement in the balance of trade will depend upon whether the demand for
imports and exports is elastic or inelastic. Devaluation makes the imports of the devaluing
country costlier than before and in case her demand for imports is inelastic, a higher amount will
be spent for the same imports, thereby worsening her balance of trade.
Similarly, if her export demand is inelastic, then, after devaluation, lesser amount will be spent
by the foreigners thereby affecting adversely the balance of payments of the devaluing country.
However, if her demand for exports is elastic then with a fall in the prices of the exports as a
result of devaluation, more will be purchased by the foreigners, which, in turn, will help in
restoring the equilibrium in her balance of payments. Likewise, if her demand for imports is
elastic, then the imports of the country will be significantly reduced by devaluation, which in
turn would improve the balance of payments of the devaluing country.
The success of devaluation in improving the balance of trade also depends on the reactions of her
trading partners. If the trading partners retaliate, then devaluation will not make any impact on
the imports or exports of the devaluing country, even though her demand of imports and exports
may be elastic.
2.4. Approaches of Balance of Payments
The following points highlight the top three approaches of balance of payments. The approaches
are:
1. The Elasticity Approach
2. The Absorption Approach
3. The Monetary Approach.
1. The Elasticity Approach:
Marshall-Lerner Condition:
The elasticity approach to BOP is associated with the Marshall-Lerner condition which was
worked out independently by these two economists. It studies the conditions under which
exchange rate changes restore equilibrium in BOP by devaluing a country’s currency. This
approach is related to the price effect of devaluation.
Assumptions:
This analysis is based on the following assumptions:
1. Supplies of exports are perfectly elastic.
2. Product prices are fixed in domestic currency.
3. Income levels are fixed in the devaluing country.
4. The supply of imparts are large.
5. The price elasticities of demand for exports and imports are arc elasticities.
6. Price elasticities refer to absolute values.
7. The country’s current account balance equals its trade balance.
Given these assumptions, when a country devalues its currency, the domestic prices of its
imports are raised and the foreign prices of its exports are reduced. Thus devaluation helps to
improve BOP deficit of a country by increasing its exports and reducing its imports.
But the extent to which it will succeed depends on the country’s price elasticities of domestic
demand for imports and foreign demand for exports. This is what the Marshall-Lerner condition
states: when the sum of price elasticities of demand for exports and imports in absolute terms is
greater than unity, devaluation will improve the country’s balance of payments, i.e.
Ex + em > 1
where ex is the demand elasticity of exports and Em is the demand elasticity for imports. On the
contrary, if the sum of price elasticities of demand for exports and imports, in absolute terms, is
less unity, ex + em< 1, devaluation will worsen (increase the deficit) the BOP. If the sum of these
elasticities in absolute terms is equal to unity, ex + em = 1, devaluation has no effect on the BOP
situation which will remain unchanged.
The following is the process through which the Marshall-Lerner condition operates in removing
BOP deficit of a devaluing country. Devaluation reduces the domestic prices of exports in terms
of the foreign currency. With low prices, exports increase.
The extent to which they increase depends on the demand elasticity for exports. It also depends
on the nature of goods exported and the market conditions. If the country is the sole supplier and
exports raw materials or perishable goods, the demand elasticity for its exports will be low.
If it exports machinery, tools and industrial products in competition with other countries, the
elasticity of demand for its products will be high, and devaluation will be successful in correcting
a deficit.
Devaluation has also the effect of increasing the domestic price of imports which will reduce the
import of goods. By how much the volume of imports will decline depends on the demand
elasticity of imports. The demand elasticity of imports, in turn, depends on the nature of goods
imported by the devaluing country.
If it imports consumer goods, raw materials and inputs for industries, its elasticity of demand for
imports will be low. It is only when the import elasticity of demand for products is high that
devaluation will help in correcting a deficit in the balance of payments. Thus it is only when the
sum of the elasticity of demand for exports and the elasticity of demand for imports is greater
than one that devaluation will improve the balance of payments of a country devaluing its
currency.
The J-Curve Effect
Empirical evidence shows that the Marshall- Lerner condition is satisfied in the majority of
advanced countries. But there is a general consensus among economists that both demand-supply
elasticities will be greater in the long run than in the short run. The effects of devaluation on
domestic prices and demand for exports and imports will take time for consumers and producers
to adjust themselves to the new situation.
The short-run price elasticity of demand for exports and imports are lower and they do not satisfy
the Marshall-Lerner condition. Therefore, to begin with, devaluation makes the BOP worse in
the short- run and then improves it in the long-run. This traces a J-shaped curve through time.
This is known as the J-curve effect of devaluation.
However, in case the country is on a flexible exchange rate, BOP will get worse when there is
devaluation of its currency. Due to devaluation, there is excess supply of currency in the foreign
exchange market which may go on depreciating the currency. Thus the foreign exchange market
becomes unstable and the exchange rate may overshoot its long-run value.
2.5. Criticisms of Elasticity Approach
The Elasticity approach based on the Marshall-Lerner condition has the following defects:
1. Misleading:
The elasticity approach which applies the Marshallian concept of elasticity to solve BOP deficit
is misleading. This is because it has relevance only to incremental change along a demand or
supply curve and to problems dealing with shifts in these curves. Moreover, it assumes constant
purchasing power of money which is not relevant to devaluation of the country’s currency.
2. Partial Elasticities:
The elasticity approach has been criticised by Alexander because it uses partial elasticities which
exclude all factors except relative prices and quantities of exports and imports. This is applicable
only to single-commodity trade rather than to a multi-commodity trade. It makes this approach
unrealistic.
3. Supplies not Perfectly Elastic:
The Marshall-Lerner condition assumes perfectly elastic supplies of exports and imports. But
this assumption is unrealistic because the country may not be in a position to increase the supply
of its exports when they become cheap with devaluation of its currency.
4. Partial Equilibrium Analysis:
The elasticity approach assumes domestic price and income levels to be stable within the
devaluing country. It, further, assumes that there are no restrictions in using additional resources
into production for exports. These assumptions show that this analysis is based on the partial
equilibrium analysis.
It, therefore, ignores the feedback effects of a price change in one product on incomes, and
consequently on the demand for goods. This is a serious defect of the elasticity approach because
the effects of devaluation always spread to the entire economy.
5. Inflationary:
Devaluation can lead to inflation in the economy. Even if it succeeds in improving the balance of
payments, it is likely to increase domestic incomes in export and import-competing industries.
But these increased incomes will affect the BOP directly by increasing the demand for imports,
and indirectly by increasing the overall demand and thus raising the prices within the country.
6. Ignores Income Distribution:
The elasticity approach ignores the effects of devaluation on income distribution. Devaluation
leads to the reallocation of resources. It takes away resources from the sector producing non-
traded goods to export and import-competing industries sector. This will tend to increase the
incomes of the factors of production employed in the latter sector and reduce that of the former
sector.
7. Applicable in the Long Run:
As discussed above in the J-curve effect of devaluation, the Marshall-Lerner condition is
applicable in the long-run and not in the short. This is because it takes time for consumers and
producers to adjust themselves when there is devaluation of the domestic currency.
8. Ignores Capital Flows:
This approach is applicable to BOP on current account or balance of trade. But BOP deficit of a
country is mainly the result of the outflow of capital. It thus ignores BOP on capital account.
Devaluation as a remedy is meant to cut imports and the outflow of capital and increase exports
and the inflow of capital.
Conclusion:
There has been much controversy over the Marshall-Lerner condition for improvements in the
balance of payments. Economists tried to measure demand elasticities in international trade.
Some economists found low demand elasticities and others high demand elasticities.
Accordingly, the former suggested that devaluation was not an effective method while the latter
suggested that it was a potent mechanism of balance of payments adjustment. But it is difficult to
generalize due to these diverse findings on account of differences in the volume and structure of
foreign trade.
2. The Absorption Approach:
The absorption approach to balance of payments is general equilibrium in nature and is based on
the Keynesian national income relationships. It is, therefore, also known as the Keynesian
approach. It runs through the income effect of devaluation as against the price effect to the
elasticity approach.
The theory states that if a country has a deficit in its balance of payments, it means that people
are ‘absorbing’ more than they produce. Domestic expenditure on consumption and investment
is greater than national income. If they have a surplus in the balance of payments, they are
absorbing less. Expenditure on consumption and investment is less than national income. Here
the BOP is defined as the difference between national income and domestic expenditure.
This approach was developed by Sydney Alexander. The analysis can be explained in the
following form Y = C + Id + G + X-M … (1) where Y is national income, C is consumption
expenditure, total domestic investment, G is autonomous government expenditure, X represents
exports and M imports.
The sum of (C + Id + G) is the total absorption designated as A, and the balance of payments (X
– M) is designated as B. Thus Equation (1) becomes
Y=A+B
or B = Y-A …(2)
Which means that BOP on current account is the difference between national income (Y) and
total absorption (A). BOP can be improved by either increasing domestic income or reducing the
absorption. For this purpose, Alexander advocates devaluation because it acts both ways. First,
devaluation increases exports and reduces imports, thereby increasing the national income.
The additional income so generated will further increase income via the multiplier effect. This
will lead to an increase in domestic consumption. Thus the net effect of the increase in national
income on the balance of payments is the difference between the total increase in income and the
induced increase in absorption, i.e.,
DB = DY-DA … (3)
Total absorption (DA) depends on the marginal propensity to absorb when there is devaluation.
This is expressed as a. Devaluation also directly affects absorption through the change in income
which we write as D. Thus
DA = a DY + DD … (4)
Substituting equation (4) in (3), we get
DB = DY-aDY-DD
or DB = (1 – a) DY-DD …(5)
The equation points toward three factors which explain the effects of devaluation on BOP. They
are: (i) the marginal propensity to absorb (a), (ii) change in income (DY), and (iii) change in
direct absorption (DD). It may be noted that since a is the marginal propensity (MP) to absorb, (1
– a) is the propensity to hoard or save. These factors, in turn, are influenced by the existence of
unemployed or idle resources and fully employed resources in the devaluing country.
Effects of Devaluation on BOP:
1. MP to Absorb:
To take the MP to absorb, it is less than unity (a< 1), with idle resources in the country,
devaluation will increase exports and reduce imports. Output and income will rise and BOP on
current account will improve. If, on the other hand, a > 1, there will be an adverse effect of
devaluation on BOP.
It means that people are absorbing more or spending more on consumption and investing more.
In other words, they are spending more than the country is producing. In such a situation,
devaluation will not increase exports and reduce imports, and BOP situation will worsen.
Under conditions of full employment if a > 1, the government will have to follow expenditure
reducing policy measures along with devaluation whereby the resources of the economy are so
reallocated as to increase exports and reduce imports. Ultimately, BOP situation will improve.
2. Income Effects:
Let us take the income effects of devaluation. If there are idle resources, devaluation increases
exports and reduces imports of the devaluing country. With the expansion of export and import-
competing industries, income increases. The additional income so generated in the economy will
further increase income via the multiplier effect.
This will lead to improvement in BOP situation. If resources are fully employed in the economy,
devaluation cannot correct an adverse BOP because national income cannot rise. Rather, prices
may increase thereby reducing exports and increasing imports, thereby worsening the BOP
situation.
3. Terms of Trade Effect:
The effect of devaluation on national income is also through its effects on the terms of trade. The
conditions under which devaluation worsens the terms of trade, national income will be
adversely affected, and vice versa. Generally, devaluation worsens the terms of trade because the
devaluing country has to export more goods in order to import the same quantity as before.
Consequently, the trade balance deteriorates and national income declines.
If prices are fixed in buyer’s (other country’s) currency after devaluation, the terms of trade
improve because exports increase and imports decline. The importing country pays more for
increased exports of the devaluing country than it receives from its imports. Thus the trade
balance of the devaluing country improves and its national income rises.
4. Direct Absorption:
Devaluation affects direct absorption in a number of ways. It the devaluing country has idle
resources, an expansionary process will start with exports increasing and imports declining.
Consequently, income will rise and so will absorption. If the increase in absorption in less than
the rise in income, BOP will improve. Generally, the effect of devaluation on direct absorption is
not significant in a country with idle resources.
If the economy is fully employed and has also a BOP deficit, national income cannot be
increased by devaluing the currency. So an improvement in BOP can be brought about by
reduction in direct absorption. Domestic absorption can fall automatically as a result of
devaluation due to real cash balance effect, money illusion and income redistribution.
5. Real Cash Balance Effect:
When a country devalues its currency, its domestic prices rise. If the money supply remains
constant, the real value of cash balances held by the people falls. To replenish their cash
balances, people start saving more. This can be possible only by reducing their expenditure or
absorption. This is the real cash balance effect of devaluation.
If people hold assets and when devaluation reduces their real cash balances, they sell them. This
reduces the prices of assets and increases the interest rate. This, in turn, will reduce investment
and consumption, given the constant money supply. As a result, absorption will be reduced. This
is the asset effect of real cash balance effect of devaluation.
6. Money Illusion Effect:
The presence of money illusion also tends to reduce direct absorption. When prices rise due to
devaluation, consumers think their real incomes have fallen, even though their money incomes
have risen. They have the money illusion under whose influence they reduce their consumption
expenditure or direct absorption.
7. Income Re-distribution Effect:
Direct absorption falls automatically if devaluation redistributes income in favour of people with
high marginal propensity to save and against those with high marginal propensity to consume. If
the marginal propensity to consume of workers is higher than those of profit-earners, absorption
will be reduced.
Further, when money incomes of lower income groups increase with devaluation, they enter the
income tax bracket. When they start paying income tax, they reduce their consumption as
compared with higher income groups which are already paying the ‘tax. This leads to reduction
in absorption in case of the former.
Income redistribution also takes place between production sectors after devaluation. Those
sectors whose prices rise more than their costs of production earn more profits than the other
sectors whose costs rise more than their prices. Thus the effect of devaluation will be to
redistribute income in favour of the former sectors.
Devaluation will also redistribute income in favour of sectors producing and selling traded goods
and against non-traded goods sectors. Prices of traded goods rise more than that of non-traded
goods. As a result, profits of producers and traders and wages of workers producing traded goods
rise more as compared to those engaged in non-traded goods.
8. Expenditure-Reducing Policies:
Direct absorption is also reduced if the government adopts expenditure- reducing monetary-fiscal
policies which are deflationary. They will make devaluation successful in reducing
BOP deficit. But they will create unemployment in the country.
2.6. Criticisms of Absorption Approach
The absorption approach to BOP deficit has been criticised on the following grounds:
1. Neglects Price Effects:
This approach neglects the price effects of devaluation which are very important.
2. Calculation Difficult:
Analytically, it appears to be superior to the elasticity approach but propensities to consume,
save and invest cannot be accurately calculated.
3. Ignores Effects on Other Countries:
The absorption approach is weak in that it relies too much on policies designed to influence
domestic absorption. It does not study the effects of a devaluation on the absorption of other
countries.
4. Not Operative in a Fixed Exchange Rate System:
The absorption approach fails as a corrective measure of BOP deficit under a fixed exchange rate
system. When prices rise with devaluation, people reduce their consumption expenditure. With
money supply remaining constant, interest rate rises which brings a fall in output along with
absorption. Thus devaluation will have little effect on BOP deficit.
5. More Emphasis on Consumption:
This approach places more emphasis on the level of domestic consumption than on relative
prices. A mere reduction in the level of domestic consumption for reducing absorption does not
mean that resources so released will be redirected for improving BOP deficit.
3. The Monetary Approach
The monetary approach to the balance of payments is an explanation of the overall balance of
payments. It explains changes in balance of payments in terms of the demand for and supply of
money. According to this approach, “a balance of payments deficit is always and everywhere a
monetary phenomenon.” Therefore, it can only be corrected by monetary measures.
Assumptions
This approach is based on the following assumptions:
1. The Taw of one price’ holds for identical goods sold in different countries, after allowing for
transport costs.
2. There is perfect substitution in consumption in both the product and capital markets which
ensures one price for each commodity and a single interest rate across countries.
3. The level of output of a country is assumed exogenously.
4. All countries are assumed to be fully employed where wage price flexibility fixes output at
full employment.
5. It is assumed that under fixed exchange rates the sterilisation of currency flows is not possible
on account of the law of one price globally.
6. The demand for money is a stock demand and is a stable function of income, prices, wealth
and interest rate.
7. The supply of money is a multiple of monetary base which includes domestic credit and the
country’s foreign exchange reserves.
8. The demand for nominal money balances is a positive function of nominal income. The
Theory
Given these assumptions, the monetary approach can be expressed in the form of the following
relationship between the demand for and supply of money:
The demand for money (MD) is a stable function of income (Y), prices (P) and rate of interest (i)
MD=f(Y, P ,i) ……(1)
The money supply (Ms) is a multiple of monetary base (m) which consists of domestic money
(credit) (D) and country’s foreign exchange reserves (R). Ignoring m for simplicity which is a
constant,
Ms = D + R …..(2)
Since in equilibrium the demand for money equals the money supply,
Md = Ms …(3)
or Md = D + R [MS = D + R] …(4)
A balance of payments deficit or surplus is represented by changes in the country’s foreign
exchange reserves. Thus
Δ R = DMD -DD … (5)
or Δ R = B …(6)
where B represents balance of payments which is equal to the difference between change in the
demand for money (DMd) and change in domestic credit (DD).
A balance of payments deficit means a negative B which reduces R and the money supply. On
the other hand, a surplus means a positive B which increases R and the money supply. When B =
O, it means BOP equilibrium or no disequilibrium of BOP.
The automatic adjustment mechanism in the monetary approaches is explained under both the
fixed and flexible exchange rate systems.
Under the fixed exchange rate system, assume that MD = Ms so that BOP (or B) is zero. Now
suppose the monetary authority increases domestic money supply, with no change in the demand
for money. As a result, Ms > M0 and there is a BOP deficit. People who have larger cash
balances increase their purchases to buy more foreign goods and securities.
This tends to raise their prices and increase imports of goods and foreign assets. This leads to
increase in expenditure on both current and capital accounts in BOP, thereby creating a BOP
deficit. To maintain a fixed exchange rate, the monetary authority will have to sell foreign
exchange reserves and buy domestic currency. Thus the outflow of foreign exchange reserves
means a fall in R and in domestic money supply. This process will continue until Ms = MD and
there will again be BOP equilibrium.
On the other hand, if Ms < MD at the given exchange rate, there will be a BOP surplus.
Consequently, people acquire the domestic currency by selling goods and securities to
foreigners. They will also seek to acquire additional money balances by restricting their
expenditure relatively to their income. The monetary authority on its part, will buy excess
foreign currency in exchange for domestic currency. There will be inflow of foreign exchange
reserves and increase in domestic money supply. This process will continue until Ms = MD and
BOP equilibrium will again be restored. Thus a BOP deficit or surplus is a temporary
phenomenon and is self-correcting (or automatic) in the long-run.
This is explained in Fig. 4 In Panel (A) of the figure, MD is the stable money demand curve and
Ms is the money supply curve. The horizontal line m (D) represents the monetary base which is a
multiple of domestic credit, D which is also constant. This is the domestic component of money
supply that is why the Ms curve starts from point C.
Ms and MD curves intersect at point £ where the country’s balance of payments is in
equilibrium and its foreign exchange reserves are OR. In Panel (B) of the figure, PDC is the
payments disequilibrium curve which is drawn as the vertical difference between Ms and
MD curves of Panel (A). As such, point B0 in Panel (B) corresponds to point E in Panel (A)
where there is no disequilibrium of balance of payments.
If Ms < M0 there is BOP surplus of SP in Panel (A). It leads to the inflow of foreign exchange
reserves which rise from OR, to OR and increase the money supply so as to bring BOP
equilibrium at point £. On the other hand, if Ms > M^ there is deficit in BOP equal to DF.
There is outflow of foreign exchange reserves which decline from OR, to OR and reduce the
money supply so as to reestablish BOP equilibrium at point £. The same process is illustrated
in Panel (B) of the figure where BOP disequilibrium is self-correcting or automatic when B,S,
surplus and B2D, deficit are equal.
Under a system of flexible (or floating) exchange rates, when B = O, there is no change in
foreign exchange reserves (R). But when there is a BOP deficit or surplus, changes in the
demand for money and exchange rate play a major role in the adjustment process without any
inflow or outflow of foreign exchange reserves. Suppose the monetary authority increases the
money supply (Ms > MD) and there is a BOP deficit. People having additional cash balances buy
more goods thereby raising prices of domestic and imported goods.
There is depreciation of the domestic currency and a rise in the exchange rate. The rise in prices,
in turn, increases the demand for money thereby bringing the equality of MD and Ms without any
outflow of foreign exchange reserves. The opposite will happen when MD > Ms, there is fall in
prices and appreciation of the domestic currency which automatically eliminates the excess
demand for money. The exchange rate falls until M0 = Ms and BOP is in equilibrium without any
inflow of foreign exchange reserves.
2.7. Criticisms of Monetary Approach
The monetary approach to the balance of payments has been criticised on a number of counts:
1. Demand for Money not Stable:
Critics do not agree with the assumption of stable demand for money. The demand for money is
stable in the long run but not in the short run when it shows less stability.
2. Full Employment not Possible:
Similarly, the assumption of full employment is not acceptable because there exists involuntary
unemployment in countries.
3. One Price Law Invalid:
Frankel and Johnson are of the view that the law of one price holds for identical goods sold is
invalid. This is because when factors of production are drawn into sectors producing non-trading
goods, the excess demand for non-traded goods will spill over into reduced supplies of traded
goods. This will lead to higher imports, and disturb the law of one price for all traded goods.
4. Market Imperfections:
There are also market imperfections which prevent the law of one price from working properly
in many markets for traded goods. There may be price differentials due to the lack of information
about overseas prices and trade regulations faced by traders.
5. Sterilisation not Possible:
The assumption that the sterilisation of currency flows is not possible under fixed exchange
rates, has not been accepted by critics. They argue that “the sterilisation of currency flows is
entirely possible if the private sector is willing to adjust the composition of its wealth portfolio
with regard to the relative importance of bonds and money balances, or if the public sector is
prepared to run a higher budget deficit whenever it has a balance of payments deficit with which
to contend.”
6. Link between BOP and Money Supply not Valid:
The monetary approach is based upon direct link between BOP of a country and its total money
supply. This has been questioned by economists. The link between the two depends upon the
ability of the monetary authority to neutralize the inflows and outflows of foreign exchange
reserves when there is BOP deficit and surplus. This requires some degree of sterilization of
external flows. But this is not possible due to globalization of financial markets.
7. Neglects Short Run:
The monetary approach is related to the self-correcting long-run equilibrium in BOP. This is
unrealistic because it fails to describe the short time through which the economy passes to reach
the new equilibrium. As pointed out by Prof. Krause, the monetary approach’s “concentration on
the long-run assumes away all of the problems that make the balance of payments a problem.”
8. Neglects Other Factors:
This approach neglects all real and structural factors which lead to disequilibrium in BOP and
concentrates only on domestic credit.
9. Neglects Economic Policy:
This approach emphasizes the role of domestic credit in bringing M equilibrium and neglects
economic policy measures. According to Prof. Currie, the balance of payments equilibrium can
also be “achieved by expenditure-switching policies working through real flows and government
budget.”
Conclusion:
Despite these criticisms, the monetary approach is realistic in that it takes into consideration both
domestic money and foreign money. Emphasis is not on relative price changes, but on the extent
to which the demand for real money balances will be satisfied from internal sources, through
credit creation or from external sources through surplus or deficit in the balance of payments.
A balance of payments deficit or surplus can be corrected through changes in money supply and
their consequent effects on income and expenditure, or more generally on production and
consumption of goods.
2.8. Crypto Currency: Meaning, Nature, Relevance and Effects
Meaning
Crypto currencies are digital financial assets, for which records and transfers of ownership are
guaranteed by a cryptographic technology rather than a bank or other trusted third party. They
can be viewed as financial assets because they bear some value (discussed below) for crypto
currency holders, even though they represent no matching liability of any other party and are not
backed by any physical asset of value (such as gold, for example, or the equipment stock of an
enterprise).
A crypto currency is a digital or virtual currency that is secured by cryptography, which makes it
nearly impossible to counterfeit or double-spend. A crypto currency is a form of digital asset
based on a network that is distributed across a large number of computers. This decentralized
structure allows them to exist outside the control of governments and central authorities.
The word “crypto currency” is derived from the encryption techniques which are used to secure
the network.
Nature
Crypto currencies can be seen as part of a broader class of financial assets, “crypto assets” with
similar peer-to-peer digital transfers of value, without involving third party institutions for
transaction certification purposes. What distinguishes crypto currencies from other crypto assets?
This depends on their purpose, i.e. whether they are issued only for transfer or whether they also
fulfill other functions. Within the overall category of crypto assets, we can follow the distinctions
drawn in recent regulatory reports, distinguishing two further sub-categories of crypto assets, on
top of crypto currencies.
Crypto currencies is an asset on a block chain that can be exchanged or transferred between
network participants and hence used as a means of payment—but offers no other benefits.
Within crypto currencies it is then possible to distinguish those whose quantity is fixed and price
market determined (floating crypto currencies) and those where a supporting arrangement,
software or institutional, alters the supply in order to maintain a fixed price against other assets
(stable coins, for example Tether or the planned Facebook Libra).
In most cases, cryptocurrency is defined as one of the known and regulated objects of civil
turnover. Thus, the Australian Taxation Office (ATO) has decided that the digital currency is a
commodity, not a currency, which corresponds to the tax instructions provided by the relevant
authorities in other countries, such as Canada and Singapore. Resolutions of ATO of December
17, 2014, stipulate that transactions in bitcoins are an analog to a barter agreement and have
similar tax consequences. ATO also notes that bitcoin is neither money nor foreign currency, and
for taxation purposes, the sale of bitcoin is not considered as a financial service. According to the
Australian Securities and Investments Commission (ASIC), the digital currencies themselves are
not included in the legal definition of a "financial product", and the digital currency trading does
not fall under the category of financial services.
A different point of view was expressed by Stephen Poloz, the Governor of the Central Bank of
Canada, who stated in January 2018 that he objected to the term "cryptocurrencies", since they
are not currencies, they are not assets, they can rather technically be classified as securities.
For a long time, Russia had no clear position of the state regarding the legal nature of
cryptocurrency and its legal status. Despite the fact that there is no direct ban on cryptocurrency
transactions, in most cases, the officials' statements and the positions of government bodies
showed a very cautious approach to the potential permission of settlements in cryptocurrency in
the Russian Federation. The Bank of Russia considered it premature to let cryptocurrencies, as
well as any financial instruments nominated or associated with cryptocurrencies, circulate and be
used at organized trades and in settlement and clearing infrastructure on the territory of the
Russian Federation for servicing deals with cryptocurrencies and their derivatives.
The Federal Tax Service of Russia stated that transactions related to the acquisition or sale of
cryptocurrency using foreign exchange values (foreign currency and external securities) and/or
currency of the Russian Federation are currency transactions thus equating cryptocurrency with
the foreign currency. To date, they have drafted and discussed a federal law "On Digital
Financial Assets", which attributes cryptocurrency to property in electronic form, created with
the use of cryptographic means. In accordance with the draft law, cryptocurrency is not
recognized as a legitimate means of payment in the territory of the Russian Federation.
One of the options for determining the legal nature of crypto currency, which has been
repeatedly proposed by officials of different countries, including Russia, is the introduction of
the concept of a "digital commodity" ("virtual commodity"). With this variant accepted, the civil
legislation should be added with norms about a new object of the civil rights - a digital (virtual)
thing. However, the extension of the real rights regime to such an object is difficult since it is
intangible. From the point of view of the civil law, only a tangible thing can be alienated,
whereas intangible objects of civil rights, including the results of intellectual activity and the
means of individualization of legal persons, goods, works, services and enterprises, are not
transferable, i. e. only the rights on them are subject to alienation.
A number of states did gradually come to understanding that equating crypto currency with the
already existing objects of civil circulation is not right. In February 2016, in the UK, the
Commonwealth Working Group on Virtual Currencies published a report on the legal status of
the digital currency and the regulation of transactions in it, which adopted the virtual currency
definition proposed by the Financial Action Task Force (FATF), a group for combating money
laundering: a digital representation of value that can be digitally traded and functions as a
medium of exchange, a unit of account and/or a stored value, but does not have legal tender
status in any jurisdiction. We believe that this definition most accurately reveals the essence of
cryptocurrency and expresses a specific position regarding its functions as a means of
accumulation, while excluding its use as a means of payment
Relevance and Effects
Cryptocurrency has already been reviewed in numerous publications in the modern academic
environment. The phenomenon is studied in its various aspects: economic and financial. They
explore advantages and disadvantages of cryptocurrency, motivation and barriers for its use ,
security of transactions in cryptocurrency, etc. At the same time, there are very few studies
aimed at determining the legal nature of cryptocurrency, without which there is no point in
talking about its legal regulation. Only with understanding what cryptocurrency as a legal
category is, one can talk about regulating its emission and turnover through legal norms.
The definition of cryptocurrency as a commodity means that transactions on its sales are to be
taxed on the added value. The exchange of cryptocurrency for goods falls under the legal
regulation of barter transactions. If cryptocurrency is recognized as a security or other financial
instrument, then the activity of cryptocurrency exchanges, similar to stock exchanges, must be
licensed by the state. Thus, the definition of the legal nature of cryptocurrency as the basis of its
legal status is a priority task that must be solved by the state before any measures are taken to
legalize cryptocurrencies.
Some economic analysts predict a big change in crypto is forthcoming as institutional money
enters the market. Moreover, there is the possibility that crypto will be floated on the Nasdaq,
which would further add credibility to blockchain and its uses as an alternative to conventional
currencies. Some predict that all that crypto needs is a verified exchange traded fund (ETF). An
ETF would definitely make it easier for people to invest in Bitcoin, but there still needs to be the
demand to want to invest in crypto, which might not automatically be generated with a fund.
Some of the limitations that cryptocurrencies presently face – such as the fact that one’s digital
fortune can be erased by a computer crash, or that a virtual vault may be ransacked by a hacker –
may be overcome in time through technological advances. What will be harder to surmount is the
basic paradox that bedevils cryptocurrencies – the more popular they become, the more
regulation and government scrutiny they are likely to attract, which erodes the fundamental
premise for their existence.
While the number of merchants who accept cryptocurrencies has steadily increased, they are still
very much in the minority. For cryptocurrencies to become more widely used, they have to first
gain widespread acceptance among consumers. However, their relative complexity compared to
conventional currencies will likely deter most people, except for the technologically adept.
A cryptocurrency that aspires to become part of the mainstream financial system may have to
satisfy widely divergent criteria. It would need to be mathematically complex (to avoid fraud and
hacker attacks) but easy for consumers to understand; decentralized but with adequate consumer
safeguards and protection; and preserve user anonymity without being a conduit for tax evasion,
money laundering and other nefarious activities. Since these are formidable criteria to satisfy, is
it possible that the most popular cryptocurrency in a few years’ time could have attributes that
fall in between heavily-regulated fiat currencies and today’s cryptocurrencies? While that
possibility looks remote, there is little doubt that as the leading cryptocurrency at present,
Bitcoin’s success (or lack thereof) in dealing with the challenges it faces may determine the
fortunes of other cryptocurrencies in the years ahead.
here is already an entire industry built around cryptocurrencies and it’s held by institutions
dedicated to supervising all the digital coin exchanges taking place throughout the world. The
rate at which the cryptocurrency industry is growing is earth-shattering and this can be confirmed
by early adopters that became rich overnight and found opportunities to grow financially.
Bitcoin, the most famous of these cryptocurrencies, has already permitted many people and
companies to develop and flourish, while many also rely on trading as their source of income.
The economy is slowly shifting to adapt to these needs and cryptocurrencies have a great
potential in satisfying them.
Great Opportunities for Poorly Banked Countries
More than a third of the world population does not have access to basic banking services that can
help them out in case of a personal financial crisis - loans, checking accounts and the list can go
on. These people that in most cases are already financially disadvantaged typically resort to
doubtful and dangerous lending practices. The interest rate of these practices is anything but fair,
which consequently leads to more instability among the people who requested the loan. This is
where cryptocurrencies come in with their high volatility and ease-of-use.
Low Transaction Costs
Because cryptocurrencies and blockchain don’t need an actual brick-and-mortar building to exist,
the costs associated with their transactioning are minimal. There is no need for employee wages,
utility bills or rent to be paid, so these savings naturally morph into low transaction fees. This in
turn encourages more and more people to trust these new financial tools and start transactioning,
allowing for the global economy to be more closely intertwined. And depending on the broker
you choose, you can even trade with no minimum deposit requirements - as offered by
CryptoRocket, for example.
Increased Transpararency of Transactions
Since all blockchain and cryptocurrencies transactions are automated and digitized, they are all
tracked in a distributed ledger. The best part about it is that it cannot be manipulated by either
people or companies, which greatly diminishes the risk of fraud and corruption. This means that
underdeveloped countries also have a greater chance of entering the financial transactions game
and boost their own economy and social prospects. What’s more, citizens will be able to keep
track of where state funds will be oriented and will thus have a say within their own political
climate.
More Power to Entrepreneurs
There’s never been a more prosperous time to do business than it is now, in the sense that
blockchain technology and cryptocurrencies can help entrepreneurs receive payments in more
currencies. BitPesa is one such company that helps business owners in Africa make financial
transactions with European, American and Asian companies. The aim is to help small and
medium business everywhere get better financial coverage and a liberated financial connection
with the rest of the world.
2.9. Tariff and Non-Tariff Instruments of Trade Policy
Meaning of Tariffs:
A tariff is a duty or tax imposed by the government of a country upon the traded commodity as it
crosses the national boundaries. Tariff can be levied both upon exports and imports. The tariff or
duties imposed upon the goods originating in the home country and scheduled for abroad are
called as the export duties. Countries, interested in maximising their exports generally avoid the
use of export duties. Tariffs have, therefore, become synonymous with import duties.
The import duties or import tariffs are levied upon the goods originating from abroad and
scheduled for the home country. Sometimes a country may also resort to what is called as a
transit duty. It is imposed upon the goods originating in the foreign country and scheduled for a
third country crossing the borders of the home country. For instance, if India imposes tariffs on
goods that Bangladesh exports to Nepal through the Indian Territory, these will be called as
transit duties. Such duties are usually a matter of much concern for the land-locked countries.
The imposition of import tariff results in the relative changes in prices of products and factors.
That brings about a significant change in the structure of international trade. High tariffs
certainly have the effect of restricting the volume of international trade. A negative tariff or
subsidy is often supposed to expand foreign trade over and above its volume in the absence of
subsidy.
Types of Tariffs:
Tariffs are of several types and these can be classified into different groups or sub-groups as
below:
(1) Classification on the Basis of Criterion for Imposition:
On the basis of the criterion for imposition of tariffs.
These can be of such types as:
(a) Specific tariff,
(b) Ad Valorem tariff,
(c) Compound tariff and
(d) Sliding scale tariff.
(a) Specific Tariff:
Specific tariff is the fixed amount of money per physical unit or according to the weight or
measurement of the commodity imported or exported. Such duties can be levied on goods like
wheat, rice, fertilisers, cement, sugar, cloth etc. Specific duties are quite easy to administer, as
they do not involve the evaluation of the goods.
The determination of the value of the traded goods may be difficult as there are several variants
of price such as demand price, supply price, market price, contract price, invoice price, f.o.b,
(free on board) price, c.i.f (cost, insurance, freight) price etc. The resort to specific duties enables
the government to keep out of complexities of prices.
However, the specific duties cannot be levied on high valued goods such as diamonds, jewellery,
watches, T.V. sets, motor cars, works of arts like paintings etc. These articles can be taxed either
on the basis of weight, surface area covered or the number of articles.
(b) Ad Valorem Tariff:
‘Ad Valorem’ is the Latin word that means ‘on the value.’ When the duty is levied as a fixed
percentage of the value of the traded commodity, it is called as valorem tariff. Such duties are
levied on the products the value of which is disproportionately higher compared to their physical
characteristics such as weight or measure-ment.
These duties are more equitable as the costly goods, generally consumed by the rich, bear greater
burden of duty, while the cheaper goods bought by the poor, bear lesser burden of tariff. For
instance, if the import of watches is subject to 70 percent ad valorem tariff, a watch valued at Rs.
1000 will be subject to a duty of Rs. 700 and a watch valued at Rs. 1200 will be subject to a tariff
amounting to Rs. 840. The ad valorem duties have an additional advantage that the international
comparison of tariffs, in their case, can be easily made.
(c) Compound Tariff:
The compound tariff is a combination of specific and ad valorem tariff. The structure of
compound tariff includes specific duty on each unit of the commodity plus a percentage of ad
valorem duty. The compound tariffs not only impart a greater elasticity to revenues but also
assure a more effective protection to the home industries.
(d) Sliding Scale Tariff:
The import duties which vary with the prices of the commodities are termed as sliding scale
duties. These may either be on specific or ad valorem basis. In practice, these are generally on a
specific basis.
(2) Classification on the Basis of Purpose for Which Tariff is Imposed:
On the basis of purpose of levying the tariff.
These can be of two types:
(a) Revenue Tariff and
(b) Protective Tariff.
(a) Revenue Tariff:
The tariff, which is imposed primarily for generating more revenues for the government is called
as the revenue tariff. In advanced countries, the introduction and diversification of direct taxes
has reduced the importance of tariff as a source of government revenues. But in the less
developed countries, there is still much reliance of the governments on this source of revenue.
Generally pure revenue tariff is not possible. The imposition of tariff, even for the purpose of
securing revenues, does have protective effect when it leads to switch of demand by the domestic
consumers from the imported to home- produced goods.
(b) Protective Tariff:
The tariff may be imposed by the government to protect the home industries from the cut-throat
competition from the foreign produced goods. The higher the tariff, greater may be the protective
effect of tariff. A perfect protective tariff is likely to prohibit completely the import from abroad.
In practice, the perfect protective tariff may not exist. If the domestic demand for import remains
strong, there can be the possibility of smuggling imported goods. In addition, such a tariff will
not yield any revenue to the government. A high rate of protective tariff can make the domestic
producers more lethargic and inefficient and unable to face foreign competition even in the long
run.
(3) Classification on the Basis of Discrimination:
If the tariff is influenced by the consideration of discrimination.
There can be two types of tariffs-
(a) Non-discriminatory and
(b) Discriminatory.
(a) Non-Discriminatory Tariff:
If the uniform tariff rates are applicable to all the commodities irrespective of the country of
origin, these are known as non-discriminatory tariffs. It is possible that low rates of tariffs on
certain commodities exist because of commercial agreements with some countries but the tariff-
imposing home country extends the same low tariff rates to the commodities of all the countries.
Such a system of non-discriminatory tariff is called as single column tariff. This system of tariff
is easy and simple to administer. There is, however, one deficiency that it is not elastic enough to
adjust according to the changing needs of the industries of the home country. From the viewpoint
of revenues too, it may not be satisfactory for the tariff-imposing country.
(b) Discriminatory Tariff
In case of discriminatory tariff, the varying tariff rates exist for different commodities. The
products originating from favoured countries are subject to a lower tariff rate than those of other
countries. The discriminatory tariffs can be double or multiple column tariffs.
In case of the double column tariff, two different rates of duty exist for all or some commodities.
Both the rates are either announced by the government right from the beginning and the two rates
come into existence after the country enters into favoured-nation commercial agreement with
some foreign countries. The favoured rates of tariff may either be on a unilateral basis or on a
reciprocal basis.
The double column tariff can be further classified as:
(i) General and conventional tariff
(ii) Maximum and minimum tariff
(iii) Multiple Column Tariff.
(i) General and Conventional Tariff:
The general tariff schedule is determined by the state legislature. It also makes provision for the
adjustment in tariff rates as and when required to fulfill the obligations of international
commercial agreements. The conventional tariff schedule is evolved through the commercial
agreements of the home country with other countries. It does not permit changes in tariff rates
according to the changes in domestic conditions or requirements.
The changes can be possible only after negotiations and agreements are reached between the
concerned countries or after the expiry of the existing agreement. It is clear that there is some
rigidity in the conventional tariff schedule. In contrast, the general tariff schedule is more
flexible
(ii) Maximum and Minimum Tariff
Under this system, a country has maximum and minimum tariff rates for every commodity.
These tariff rates are fixed by the legislature and the government is authorised to apply specific
rates of tariff to the goods imported from the different countries. The minimum tariff rates are
applied to the products originating from the countries treated as ‘The Most Favoured Nations’.
The maximum tariff rates are applied for the purpose of improving the bargaining position of the
home country vis-a-vis the foreign countries.
(iii) Multiple Column Tariff:
The multiple column tariff consists of three different rates of tariff – a general rate, an
international rate and a preferential rate. The general and international tariff rates can be
considered equivalent to the maximum and minimum tariff rates discussed above. The
preferential tariff is generally applied by a subject country to the products originating from the
colonial countries.
The preferential tariff rate is kept lower than the general rate of tariff. For instance, the goods
imported by India from Britain before independence were subjected to a lower tariff or duty free
on account of Imperial Preferences. On the other hand, the goods imported from other countries
such as Japan, Germany and others were subject to higher rates of tariff.
(4) Classification on the Basis of Products:
Whether a product is imported or exported can be the basis of tariff.
On this basis, the tariffs can be of the types of:
(a) Import duties and
(b) Exports duties.
(a) Import Duties:
If the home country imposes tariff upon the products of the foreign countries as they enter its
territory, the tariff is known as import tariff or import duty.
(b) Export Duties:
If the products of the home country become subject to tax as they leave its territory to be sold in
the foreign market, the tax or duty is called as export tariff or export duty.
The import tariffs have remained the matter of deep interest both for analytical and policy
reasons. These are far more wide-spread, and almost every country takes resort to them. In
contrast, the export duties are applied to a very limited extent. Some countries like the USA have
prohibited export duties by law. Even in those countries, where these are in vogue, the basic
purpose is to secure larger revenues.
(5) Classification on the Basis of Retaliation:
On this basis, the tariffs can be of the types of
(a) Retaliatory tariffs and
(b) Countervailing tariffs.
(a) Retaliatory Tariffs:
If a foreign country has imposed tariffs upon the exports from the home country and the latter
imposes tariffs against the products of the former, the tariffs resorted to by the home country will
be regarded as the retaliatory tariffs. The home country, while adopting this measure does not
either has the object of raising revenues or protecting home industries but of acting in retaliation.
(b) Countervailing Tariffs:
If the foreign country has been exporting large quantities of its products in the market of the
home country on the strength of export subsidies, the home country can neutralise the ‘unfair
advantage’ enjoyed by foreign products through imposing duties upon them as they enter the
territory of the home country. The latter has full justification for resorting to these countervailing
duties in order that the unfair advantage given by exports subsidies to the foreign products is
offset and the competition takes place on equal footing between the foreign and home produced
goods.
Non-Tariff Instruments of Trade Policy
The trade barriers other than import quotas include voluntary export restraints, technical,
administrative and other regulations, trade restrictions due to international cartels, dumping and
export subsidies. During the recent decades, many countries have started relying increasingly
upon these forms of protectionism.
1. Voluntary Export Restraints (VER):
These restraints refer to a situation in which the importing country, faced with excessive
competition from industries of the exporting country, threatens to put stiffer all round trade
restrictions. That may induce the exporting country to-reduce the flow of exports voluntarily to
the importing country.
The United States and other industrial countries have successfully negotiated with Japan since
1950’s to make the latter curtail its exports of textiles to them. During 1980’s again U.S.A.
employed this method to make Japan and some other countries to reduce voluntarily their exports
of automobiles, steel, shoes and certain agricultural commodities.
The voluntary export agreement sometimes covers more than one country. The most famous
example of such an agreement is the Multi-Fiber Agreement (MFA) that restricted textile exports
from 22 countries.
The effects of VER upon the importing country may be explained through Figure.
In the Figure D is the domestic demand curve and S1 is the domestic supply curve of good.
Originally the world supply curve of the good at price OP0 is S0. The quantity imported is QQ1.
If the exporting and importing countries enter the voluntary export agreement about the import of
Q2Q3 quantity by the home country at the price OP1, the world supply curve shifts to S0’. The
domestic supply curve shifts to S1‘.
The net loss to the importing home country is measured by the area (A + B + C). In case of
tariffs, the area B represents the revenue gain to the government of the importing country. In case
of equivalent VER, the equivalent amount is taken away by the foreign exporters in the form of
rents. It is in fact this consideration of rent that makes the foreign suppliers to enter into the
voluntary export arrangement.
The foreign suppliers enter into such an agreement because they can later supply high cost or
luxury item to the importing country and increase their rent earnings. In addition, such an
agreement allows them to have an opportunity of protected market for their products. There is
also the fear that not making of such as an agreement will result in tariffs or other restrictions
upon their exports.
The voluntary export restraints, if successful, will have exactly similar effects as are associated
with import quotas. The only difference in that these are administered by the exporting country.
The voluntary export restraints are likely to be less effective for various reasons. Firstly, the
exporting countries are very reluctant in agreeing to these restraints. Generally, such agreements
involve protracted negotiations.
Secondly, the agreement may be binding upon a specific country. As exports are reduced by the
given exporting country, the other countries may enter the market and enlarge their exports. It
means there is no reduction in imports but only a replacement of imports from one country by
those from the other.
Thirdly, the country, forced to restrict the export of the commodity of a particular price and
quality specification, may fill up its quota of market through products of upgraded quality
specification and a higher level of price.
Fourthly, the exporting country, may continue to export through the third country trade.
Fifthly, this measure can be successfully employed by an economically powerful country like the
U.S.A.
The less developed countries, faced with competition from the products of advanced countries,
cannot force the latter to scale down their exports.
Sixthly, the VER result in the worsening of the terms of trade in the case of importing country
because the domestic price of exporting country’s product is higher than the international price.
Seventhly, the VER discriminate against the low cost exporters. It is possible that imports are
made from the higher cost exporters resulting in an increase in the bill of the importing country.
If the advanced countries resort to this measure against the exports of manufactured goods from
the less developed countries, it can have ruinous effect upon their programme of industrialisation
in particular and economic growth in general.
2. Technical, Administrative and Other Regulations:
Another non-tariff barrier to international trade is in the form of numerous technical,
administrative and other regulations. Among these regulations are included the safety regulations
for automobiles and several other categories of machines, health regulations related to
production and packaging of edible products, patent and copyright provisions and labeling
requirements showing origin and constant.
Some of these regulations are, undoubtedly, legitimate, while some are meant essentially for
protecting domestic production against imports from abroad. For instance, French ban on
advertisement of Scotch whisky, British restriction on the showing of foreign films on British
T.V. are veiled devices for restricting imports.
Still another form of trade restriction is one, which has emanated from laws. For example, ‘Buy
American’ Act passed in the U.S.A. in 1933 provided for procurements by the government
agencies.
These procurement plans assure price advantage to the domestic suppliers. Many countries,
including both the advanced and less developed countries, have their procurement programmes
out of the domestic production. The Tokyo Round of GATT negotiations led to an agreement
that countries would avoid such practices and allow the foreign suppliers also a fair chance. One
more form of restrictions on trade is the tax rebates given to the exporters from such indirect
taxes as sales tax, excise duty and value added taxes.
This practice is extensively followed by both less developed and the advanced countries to place
their respective exporters in a relatively better position. The trade is also restricted by such
measures as international commodity agreements, multiple exchange rates, government
procurements, customs valuation and classification, stiff import licensing procedures, local
content regulations etc.
All these measures are clearly intended to benefit the home country at the expense of the rest-of-
the-world. No doubt, there is need for removing these trade barriers but much progress in this
direction is not likely to take place in the near future. The advanced countries like the U.S.A.
want to maintain the trade restrictions against the other countries.
As regards other countries, they are being pressurised to liberalise trade. Such an attitude is a
major hindrance in the dismantling of the regime of technical, administrative and other
regulations.
3. Trade Restrictions due to International Cartels:
An international cartel is an organization of suppliers of a commodity located in different
countries that agrees to restrict output and export of the given commodity with the object of
increasing or maximising profits. According to Kindelberger, “Cartels are business agreements
to regulate price, division of markets or other aspects of enterprises.”
In the opinion of Haberler, the international cartel is an act of “uniting the producers in a given
branch of industry, of as many countries as possible, into an organisation to exercise a single
planned control over production and price and possibility to divide markets between the different
producing countries.”
The most prominent example of international cartel is OPEC (Organization of Petroleum
Exporting Countries) which by restricting output and exports, could push up the price of crude
oil by four times between 1973 and 1974. Another instance of international cartel is International
Air Transport Association (IATA) which is a cartel of major international airlines. It meets
annually to prescribe international air fares and policies.
The international cartels are likely to be successful, if they fulfill certain requirements. Firstly,
there are only a few suppliers of the given commodity.
Secondly, the suppliers are amenable to discipline and uniform business conduct.
Thirdly, the product is produced on a large scale and not by the small or medium-sized firms.
Fourthly, the commodity is such for which no close substitutes are available.
There is greater scope for the formation of international cartels in such group of industries,
as have the following characteristics:
(i) The industries are those which hold control over certain important materials or other raw
materials and the supply of which can be easily brought under effective and strict control as
petroleum, iron, aluminum, sulphur etc.
(ii) International cartels can be organised among such industries whose products are patented as
in the case of electrical and electronic industries, chemicals, drugs and pharmaceutical industries.
(iii) Cartels can exist among those groups of industries, which enjoy economies of large-scale
production in an abundant measure.
Assumptions:
The operations of an international cartel related to regulation of price and output can be
discussed under the following assumptions:
(i) Cartel is concerned with a specified product such as oil, gas, iron ore etc.
(ii) The suppliers of the given commodity are only a few and they export it to other countries of
the world.
(iii) The aim of cartel is to maximise profits.
(iv) The world demand of the commodity is known to the cartel.
(v) The world demand curve for the commodity is less elastic.
(vi) The marginal cost curve of the cartel is the lateral summation of the marginal cost curves of
the member countries.
(vii) All the member countries follow the agreed price and output regulations.
(viii) There is absence of close substitutes of the specified commodity.
(ix) There is no entry or exit of suppliers.
Given the above assumptions, the price and output policy of the international cartel can be
explained through this Figure.

In this Figure, the output or exports of cartel are measured along horizontal scale and price is
measured along the vertical scale. D is the world demand curve for the given commodity, which
is relatively less elastic. MC is the marginal cost curve of the cartel. It is determined by the
lateral summation of the MC curves of the member countries.
MR is the marginal revenue curve corresponding to the world demand curve D. Under the
conditions of perfect competition, the equilibrium is determined at E0 where demand and supply
are equal. The equilibrium quantity produced and exported in the world is OQ0 and price is OP0
under the competitive conditions. The export earnings from the commodity in such a situation
are OQ0 × OP0 = OQ0E0P0. If the individual countries form cartel, the monopoly firm emerges.
The equilibrium of the cartel gets determined at R where MR = MC. The equilibrium output or
quantity exported gets reduced to OQ1 and price gets increased to OP1. The total earning from
exports is OQ1S1P1 and the total amount of profits of the cartel is R1RS1P1. From the viewpoint
of the member countries of the cartel amount of profit R1RS1P1 is likely to be greater than profits
EE0P0 under the conditions of perfect competition, otherwise they would have not created the
cartel.
So the cartel results in gain for the member countries. But there is likely to be the welfare loss for
the rest of the world. Cartel reduces output or exports from OQ0 to OQ1 and raises the price of
the commodity from OP0 to OP1. The consumer’s surplus under competition was CE0P0. After
the formation of cartel, the consumer’s surplus gets reduced CS1P1.
The loss in consumer’s surplus for the rest of the world amounts to CE0P0 – CS1P1 = P1S1E0P0.
Thus even though cartel raises the profits of individual member countries, yet the rest of the
world suffers a substantial loss in welfare.
Arguments for International Cartels:
The organization of international cartels is supported on the following main grounds:
(i) The strong international cartels can make the importing countries to either remove or lower
the tariffs. If that happens, the welfare of the international community is likely to be maximised.
(ii) The cartels eliminate cut-throat competition and price war. That can lead to supply of
products at stable prices. Thus international cartels can ensure stability in international prices.
(iii) If international cartels exist, there is much economy in respect of wasteful spending on
advertising and cross transportation.
(iv) International cartels ensure pooling of technological know-how. The specialised and highly
standardised products can be manufactured at very low costs and made available to all the
prospective importing countries.
(v) The international cartels promote international agreements and economic co-operation.
Arguments against International Cartels:
There is strong opinion against the formation of international cartels.
The main arguments against them are as below:
(i) The organisation of cartels throttles competition and results in the exploitation of consumers
through high prices, scarcity of the commodity and sub-standard products.
(ii) The argument that international cartels pave the way for reduction in tariffs is not valid. This
benefit has not actually materialised. In the words of Haberler, “….international cartels are not a
suitable instrument for demolishing tariff walls within any measurable time. Many of the present
international cartels owe their own existence to tariffs. They are, therefore, scarcely adopted for
destroying tariffs.”
(iii) The participating firms, belonging to different countries, have to follow a uniform policy,
which may not be consistent with the economic interests of at least some of the countries.
(iv) An international cartel is formed through a loose agreement. If a member country is not
satisfied with production quota, division of market or other policies, it may decide to leave the
cartel. That threatens the existence of cartel.
(v) The successful cartels, except in the case of OPEC, are not likely to be organised in the
LDC’s dominated by agriculture and handicrafts, where production is distributed too extensively
among small producers. Most of the international cartels are formed by the advanced
industrialised countries and these have served as the instruments of exploitation of the LDC’s
and restriction of the international trade.
(vi) Any one supplier of a given product may decide to remain outside the cartel and make
unrestricted sales at the prices slightly below the price fixed by the cartel. Such a situation was
faced by OPEC too, when the countries like Britain, Norway and Mexico decided to remain
outside that organisation.
(vii) Cartels are inherently unstable as these are threatened by competition from non-members
and internal wrangling among the members.
In view of their serious shortcomings and restrictive effects upon trade and growth, the
international opinion, at least in theory, is against the formation of international cartels.
4. Export Subsidies:
An important non- tariff device to influence the international trade and especially to expand
home country’s exports is the export subsidies. The export subsidies are direct cash payments or
the grant of tax relief and subsidised loans to nation’s exporters or potential exporters and/or low
interest loans to the foreign buyers for stimulating exports.
Although the international agreements do not approve of resort to export subsidies, yet both
developed and poor countries have extensively employed this device either in an explicit or
disguised form.
During the recent years, the issue of farm subsidies became a matter of confrontation between
the United States, on the one hand, and the countries of European Union (EU) and Japan on the
other, it has resulted in the collapse of W.T.O. negotiations held at Cancun in September 2003.
The export subsidies on farm products are still a very contentions issue at Doha Round of
W.T.O. negotiations.
In 1984-86, the average rates of subsidies on farm products in Japan, the EC and the U.S.A. were
64 percent, 49 percent and 35 percent respectively. In Japan, the highest rate of subsidy among
the farm products was 96 percent in the case of wheat and the lowest rate was 16 percent in the
case of poultry. In the EC, the highest and lowest rates of subsidy were 75 percent and 18 percent
in case of sugar and eggs respectively.
In the United States, the highest and lowest rates of subsidy in that period were 76 percent and 7
percent in case of sugar and eggs respectively. The United States insisted that the EC and Japan
should scale down subsidies on the farm products so that the United States products could have
greater access to the foreign markets.
The effect of export subsidy or the cost of protection due to subsidies can be examined through
Figure. In this Figure., DX and SX are the demand and supply curve of the exportable
commodity X of the home country A. The free trade world price of the commodity is OP.

At this price, the domestic supply is OQ1 and demand is OQ so that exportable surplus is QQ1. If
PP1 per unit subsidy is extended, the price for domestic consumers and producers is OP 1. At this
price, the quantities demanded and supplied are respectively OQ2 and OQ3. The exportable
surplus expands from QQ1 to Q2O3. The increase in domestic price results in a loss in
consumer’s surplus by PEAP1. The gain in producer’s surplus, on the other hand, is PFBP1. The
cost of subsidy is PP1 × Q2Q3 = AC × AB = ACGB
Net Loss or the Cost of Protection
= Loss in Consumer’s Surplus + Cost of Subsidy – Producer’s Surplus
= PEAP1 + ACGB – PFBP1
= ΔACE + ΔBGF
Thus the redistributive effects related to export subsidies can cause a net loss in welfare in the
exporting country apart from the fact that the products of other countries will be at some
disadvantage in foreign markets. As other countries also resort to counterveiling duties or export
subsidies, there can be a serious restrictive effect upon the international trade.
5. Dumping:
The widespread impression about the term ‘dumping’ is the selling of the product in the foreign
market below cost. But that is a wrong conception of dumping. Ellsworth and Leith defined
dumping as “sales in a foreign market at a price below that received in the home market, after
allowing for transportation charges, duties and all other costs of transfer.”
In the words of Haberler, “dumping is the sale of a good abroad at the price which is lower than
the selling price of the same good at the same time and in the same circumstances (that is, under
the same conditions of payments and so-on) at home, taking account of differences in transport
costs.”
Thus the essential feature of dumping is price discrimination between the two markets. It is not
necessary that the price discrimination or dumping occurs between the home market and foreign
market. It may also take place between two regions in the home market or between two foreign
markets.
Dumping has been classified into- (i) persistent, (ii) predatory and (iii) sporadic. The persistent
dumping occurs when the domestic monopolist has a continuous policy to sell his product at a
higher price in the domestic market than in the foreign market with the object of securing
maximum profits. This kind of dumping can exist when the domestic demand for the product is
inelastic but the foreign demand for the product is highly elastic. The predatory dumping is one
in which a commodity is sold at below cost or at a lower price in the foreign market temporarily
with the object of driving the rivals out of that market.
After the object is achieved, the prices are raised to take the benefit of newly acquired monopoly
position in the foreign market. The sporadic dumping is the occasional sale of the commodity
either at below cost or at a lower price in the foreign market than in the home market for the
purpose of getting rid of unforeseen and temporary glut of inventory stocks that cannot be
disposed of in the home market.
This kind of dumping can take place, if the demand for the product in the foreign market is more
elastic than its demand in the home market.
The dumping can be successful or effective, if the following conditions exist:
(i) The producer should be a monopolist in the home market. If there are perfectly competitive
conditions in the home market, the price will be equal to the average cost or marginal cost. In
such a situation, the home producer cannot charge a lower price in the foreign market unless the
government pays out subsidy to the home producers for making larger exports.
(ii) There should not be any possibility of the cheaper goods supplied in the foreign market
flowing back to the home country. In order to prevent the flow back of the commodity, it is
important that the difference between the foreign low price and domestic high price is less than
the transport cost involved in the re-export of the commodity back to the country of origin.
Dumping is supposed to be beneficial from the point of view of the exporting country. It is
believed that dumping makes the country get rid of unintended glut which, if disposed of in the
home market, could have caused fall in prices and consequent slump in the system. If producer
incurs any loss due to price difference, it can be easily compensated by the charging of high
prices in the home market.
In the case of persistent dumping, the domestic price may be higher than before dumping only
when the production is governed by the increasing costs. Such a possibility is unlikely to exist, if
the production is governed by the law of constant cost or the law of decreasing costs. In the latter
case (decreasing costs), it is possible that the producer changes a lower price in the long run even
from the domestic buyers. In such a situation, there will be an increase in the level of welfare in
the home country.
The persistent dumping is not likely to have adverse effect even upon the importing country
because the goods are available at low prices continuously. But the effects of dumping on
production in the importing country have to be assessed carefully. If dumping occurs in respect
of consumer goods or producer goods, it may cause injury to industrial expansion. In case the
exporting country has been dumping cheap raw material, the importing country may be able to
establish some processing industries.
The persistent dumping is not likely to cause much harm to the economy of the importing
country. It is often the sporadic dumping that causes injury to the latter. That is precisely the
reason the importing countries feel the necessity of adopting counterveiling measures.
These measures include anti-dumping duties, which are equivalent to the difference between the
selling prices in the exporting and the importing countries. In addition, the importing country
may protect its industries from foreign dumping through the enforcement of import quotas.
Since the middle of 1970’s, the non-tariff barriers to trade have grown much more rapidly than
the tariff barriers. At a time when WTO and other international economic institutions have been
striving to reduce the tariff barriers, it is naturally a matter of great concern that almost half of
the world trade is presently subject to non-tariff trade barriers.
In the Uruguay Round of trade negotiations, the leading countries arrived at an agreement for
dealing with the non-tariff trade barriers. However, any such trade arrangement, to succeed, must
be fully consistent with the economic interests not only of the advanced countries but also of the
less developed countries.
2.11. Comparison of Tariff and Quota
Governments of different countries have to intervene in the area of international trade for both
economic and non-economic reasons.
Such intervention goes by the name ‘protection’. Protection means government policy of
according protection to the domestic indus-tries against foreign competition.
There are various instruments or methods of protection which aim at raising exports or reducing
imports. Here we are concerned with those methods which restrict import.
There are various methods of protection. Most important methods of protection are tariff and
quotas. A tariff is a tax on imports. It is normally imposed by the government on the imports of a
particular commodity. On the other hand, quota is a quantity limit. It restricts imports of
commodities physically. It specifies the maximum amount that can be imported during a given
time period.
We can now make a comparison between tariff and quotas in terms of partial equilibrium or
demand-supply approach. Figure below illustrates the effect of tariff. The domestic supply curve
is represented by SD while the demand curve is given by Dd.
These Two curves intersect each other at point N. And the price that is determined is known as
the autarkic price or pre-trade price (PT). If trade is free, the international price that would prevail
is assumed to be PW. At the international price PW, a country produces OA but consumes OB and
the country, therefore, imports AB.
Figure: Effects of Tariff vs Quotas
1. Effects of Tariff:
Now, if a country imposes a tariff = t per unit on its import, immediately the price of the product
will rise to Pt by the amount of tariff. This increase in price has the following effects. Since the
tariff raises the price, consumers buy less. Now the consumption declines from OB to OC. This
is called consumption effect of tariff. The second effect is the out-put effect or protective effect.
Tariff raises domes-tic output from OA to OE, this is because higher price induces producers to
produce more. The third effect is the import-reducing effect.
As tariff is imposed or tariff rate is increased, import declines from AB to EC. The fourth effect
is the revenue effect earned by the government. The government revenue is the volume of import
multiplied by the tariff i.e., the area A’B’UR. It is a transfer from consumers to government.
However, if a tariff equal to T were imposed price would have increased to PT. Consequently,
imports would drop to zero. Such a situation is called prohibitive tariff.
2. Effects of Quota:
Quotas are similar to tariff. In fact, they can be represented by the same diagram. The main
difference is that quotas restrict quantity while tariff works through prices. Thus, quota is a
quantitative limit through imports.
If an import quota of EC (Fig. above) amount is imposed then price would rise to Pt because the
total supply (domestic output plus imports) equals total demand at that price. As a result of this
quota, domestic production, consumption, and imports would be the same as those of the tariffs.
Thus, the output effect, con-sumption effect and import restrictive effect of tariff and quotas are
exactly the same. The only difference is the area of revenue. We have already seen that tariff
raises revenue for the government while quotas generate no government revenue.
All the benefits of quotas go to the producers and to the lucky importers who manage to get the
scarce and valuable import permits. In such a situation, quotas differ from tariff. However, if
import licences are auctioned off to the importers then government would earn revenue from the
auction. Under these circumstances, quotas and tariff are equivalent
3. Advantages of Quotas:
(I) Foreign Exchange Implication:
The main advantage of a quota is that it keeps the vol-ume of imports unchanged even when
demand for imported articles increases. It is because quotas make the completely elastic
(horizontal) import supply curve completely inelastic (vertical). But a tariff permits imports to
rise when demand increases, particularly if the demand for imports becomes inelastic. Thus,
quotas lead to greater foreign exchange saving compared to tariff (which may even lead to an
increase in foreign exchange spending because imports may rise even after tariff).
(ii) Precise Outcome:
Another advantage of quotas is that its outcome is more certain and precise, while the outcome
of tariff is uncertain and unclear. This is so because the volume of imports remains unchanged if
a quota is imposed. But this is not so in case of a tariff.
(iii) Flexibility:
Finally, Ingo Walter argues that “quotas tend to be more flexible, more easily imposed, and more
easily removed instruments of commercial policy than tariffs. Tariffs are often regarded as
relatively permanent measures and rapidly built powerful vested interests which make them all
the more difficult to remove.”
4. Disadvantages of Quotas:
(i) Corruption:
Quotas generate no revenue for the government. However, if the government auctions the right
to import under a quota to the highest bidder only then quotas are similar to tariff. But quotas
lead to corruption. Usually, officials charged with the allocation of import licences are likely to
be exposed to bribery. Under this situation, tariff is prefer-able to quotas.
(ii) Monopoly Profit:
Secondly, quotas creates a monopoly profit for those with import licences. This means that
consumer surplus is converted into monopoly profits. Thus, quotas are likely to lead to a greater
loss of consumer welfare. If a tariff is imposed domestic price will be equal to import price plus
tariff.
(iii) Monopoly Growth:
Thirdly, allied to this disadvantage of quotas another drawback is that quotas are much more
restrictive in effect as it restricts competition. Thus, quotas may ultimately lead to concentration
of monopoly power among the importers and exporters.
(iv) Distortion in Trade:
Finally, quotas have the tendency to distort international trade much more than tariffs since its
effects are more vigorous and arbitrary.
Thus, we will have to make a choice between tariff and quotas. A tariff is usually con-sidered a
less objectionable method of trade restriction than an equivalent quotas. A tariff permits imports
to increase when demand increases and, consequently, the government is able to raise more
revenue. In contrast, quotas are less obvious and more likely to re-main in force for an indefinite
period. For all these reasons, a tariff, while objectionable, is still preferable to quotas. WTO
condemns quotas.
2.12. Nominal and Effective Rate of Protection
Nominal rate of protection
The nominal rate of protection is the percentage tariff imposed on a product as it enters the
country. For example, if a tariff of 20 percent of value is collected on clothing as it enters the
country, then the nominal rate of protection is that same 20 percent. Nominal protection is
protection provided to final product and tariff on imports. Increase in nominal protection affects
consumers by reducing their command over goods and services – as real income declines. It
affects producer positively by increasing their profit margin and hurts them by increasing cost of
production. Nominal protection ignores cost raising effects of tariff on their inputs.
The nominal tariff rate can be expressed through the following formula:
H = (P’ – P) / P
Where h is the nominal tariff rate. P is the world price in the absence of tariff and P’ is the
domestic price of the final commodity including tariff.
Effective Rate of Protection:
Until the early 1960’s, the official rate of tariff was intended to discourage the import of final
product and to promote the domestic production in the protected industry. The rate of tariff ad
valorem on the import of final product was called as the nominal rate of tariff. A ten percent
tariff on a finished imported good was supposed to have a ten percent protection to the
domestically produced import substitute.
Higher the rate of nominal tariff, it was assured, higher would be the degree of protection and
vice-versa. In other words, the nominal rate of tariff was used to be regarded as a measure of the
degree of protection.
The writers like B. Balassa, W. Corden and H.G. Johnson suggest that the nominal rate of tariff
was not the appropriate measure of the degree of protection. According to them, the concept of
nominal rate of tariff had a serious flaw that it considered only the effect of tariff on final
imported product.
It did not recognise the structure of duties applied to the imported raw materials and intermediate
goods required in the processing of the import substitutes. A country, many often, imports a raw
material either duty-free or imposes a very low tariff rate on the imports of inputs than on the
import of final commodity.
Such a policy is adopted for encouraging domestic production and expansion of employment.
For instance, a country may import raw cotton duty free but impose a stiff rate of tariff on the
import of cloth. Such a structure of import tariff brings about a relatively larger increase in the
domestic value added.
The domestic value added equals the price of the final commodity minus the cost of the imported
inputs going into the production of the commodity. When no or lower tariffs are applied on
imported inputs than on the final imported product, the rate of protection, called as the effective
rate of production, exceeds the nominal tariff rate.
The concept of effective rate of protection has been defined by Balassa in these words- “Under
the usual assumptions of international -immobility of labour and capital, the effective rate of
duty will indicate the degree of protection of the value added in the manufacturing process.” In
other words, the effective rate of tariff establishes a relationship between the tariff and the
domestic value added. Such a tariff rate can be a true measure of the actual rate of protection that
the nominal tariff affords to the domestic import-competing industries. In the words of Corden,
“The effective protective rate is the percentage increase in value added per unit in an economic
activity which is made possible by the tariff structure relative to the situation in the absence of
tariff but with the same exchange rate”.
Assumptions of Effective Rate of Protection:
Corden’s theory of effective rate of protection rests upon the following main assumptions:
(i) There is constancy of physical input- output co-efficients.
(ii) The primary inputs are available in fixed quantities.
(iii) The primary inputs are immobile between the countries.
(iv) The elasticity co-efficients related to demand for all exports and supply of all imports are
infinite.
(v) Trade takes place in case of all the inputs.
(vi) The economic system is maintained in the state of full employment through appropriate
monetary and fiscal policies.
(vii) All tariffs and other measures like taxes or subsidies are applied on a non-discriminatory
basis.
(viii) All tradable goods continue to remain tradable even after tariff and other measures are
adopted so that the domestic price of each importable good is given by the foreign price plus
tariff.
Given the above assumptions, the distinction between the nominal and effective rate of
protection can be understood through an illustration. Suppose imported special steel worth Rs.
10,000 is required for producing domestically a machine. The free trade price of machine is Rs.
16,000. If 25 percent nominal tariff is imposed on each imported machine, its price for domestic
consumer will be Rs. 20,000. Out of this, Rs. 10,000 represent imported steel, Rs. 6,000 is the
domestic value added and Rs. 4,000 is the tariff.
Rs. 4,000 tariff obtained from each imported machine signifies a 25 percent nominal tariff rate
because the nominal tariff is calculated on the price of the final commodity [(4,000/16,000) ×
100 = 25 Percent]. The rate of effective tariff is, however, much larger as it is calculated on the
domestic value added. In this illustration, it amount to [(4,000/16,000) × 100 = 66.7 Percent].
It implies that 25 percent nominal tariff provides 66.7 percent of the value of domestic
processing. Thus the effective rate of protection is 2.67 times more than that indicated by the
nominal tariff. It is, in fact, the effective rate of tariff protection that is significant for the
domestic producers as it makes them expand the domestic production of machines in competition
with the imported machines.
From the viewpoint of consumers, on the opposite, the matter for concern only is that 25 percent
tariff increases the price of imported machine by Rs. 4,000. From the above illustration, the
conclusion follows that the effective rate of protection will exceed the nominal tariff rate,
whenever the imported input is admitted duty free or a lower tariff rate is imposed on the
imported input than on the final commodity produced with the imported input.
Importance of Effective Rate of Protection:
The concept of effective rate of protection has much importance as discussed below:
(i) Importance for Producers:
While the concept of nominal rate of tariff is important from the point of view of the consumers
because of their concern with the rise in the price of the final product after tariff, the concept of
effective rate of protection or tariff has significance from the viewpoint of the producers.
When a tariff is imposed on the primary inputs or raw materials, the production decisions are
likely to get affected. The tariff policies are often intended to bring about an increase in the
domestic value added.
(ii) Impact on Resource Allocation:
It cannot be controverted that the tariff structure can affect the direction of resource allocation.
To quote Corden, “Ordinary nominal tariffs apply to commodities but resources move as
between economic activities. Therefore, to discover the resource allocation effects of a tariff
structure, one must calculate the protective rate for each activity that is the effective protective
rate.”
(iii) Nature of Tariff Structure:
The concept of effective rate of protection also sheds light upon the nature of tariff structure in a
country. A widely observed feature of tariff structure in many a country is that the nominal rates
tend to be low or even zero for raw materials and rise or escalate with the degree of processing.
For instance, the nominal tariff rates may be the lowest in the case of raw cotton but may tend
higher and higher in case of yarn, cloth and apparels respectively.
(iv) Expansion of Trade:
The concept of effective rate of protection signifies that a reduction in nominal rates of tariff on
the imported raw materials needed for the domestic processing seems to be a concession for the
foreign country intended to expand the volume of trade. In fact, it results in a rise in effective
rate of protection of the user industry. The increase in protected production may actually have
opposite consequences for the volume of trade.
(v) Expansion of Infant Industries:
The concept of effective rate of protection brings home the fact how a greater degree of
protection can be afforded for rapid expansion of infant industries. It suggests that the countries
need not impose high nominal tariff rates for protecting their infant industries. A significantly
higher rate of protection can be achieved by lowering down the structure of tariff rates on
intermediate products to be used in the infant industry.
(vi) Multiple Exchange System:
The concept of effective rate of protection can be used to analyse the multiple exchange rate
system. Any exchange rate, official or market rate, assumed as a base rate may initially be taken.
Then all exchange rates applicable to imports and exports may be converted into nominal tariff
rates, import subsidies, export taxes or export subsidies. Suppose the exchange rate of capital
goods imports is Rs. 50 per dollar and the base rate is Rs. 45 per dollar.
It implies an import tariff of 11.1 percent. It can be converted into an effective rate according to
the procedure. Given sets of nominal rates, effective rates and elasticity coefficients, a single rate
of exchange can be estimated that can achieve the same balance of payments equilibrium as can
be possible through a system of multiple exchange rates.
(vii) Impact of Foreign Tariff:
This concept can be employed also for analysing the effects of foreign tariff upon the trade and
growth of the home country and necessary actions that can be taken for off-setting any adverse
effect of the foreign tariffs.
(viii) Degree of Protection:
The government and economists are interested in measuring the degree of protection extended to
different industries. The concept of effective rate of protection has crucial importance in this
respect. The tariff policies are so devised to achieve the desired effects upon the domestic
industries.
Effects of Tariff for Small and Large Countries.
Effects of a Tariff in a Small Country
When a very small nation imposes a tariff, it will not affect the prices in the world market.
However, domestic price of the importable commodity will rise by the full amount of the tariff
for individual producers and consumers in the small nation. Here, one must remember that
though price of the importable commodity increases by the full amount of the tariff for
individual producers and consumers yet its price remain constant for the small nation as a whole.
This is illustrated in Figure 2, in which, PP1 is production possibility curve. Production
possibility curve is skewed toward Y axis; this shows that India is producing more of cloth and
less of wheat. It is assumed here that cloth is a labour intensive commodity and India is a labour
abundant country. Production possibility curve is skewed toward cloth axis in the India because
cloth is labour intensive commodity and India has a relative abundance of labour. At the free
trade Pw/Pc = PA = 1 on the world market, the India (now assume to be a small nation)

produces at point A on price line PA = 1 (see Figure ) and consumes at point E on indifference
curve, I (as shown in Figure). At free trade Pw/Pc = PA = 1 on the world market, India produces
130C and 40W at point A and consumes 70C and 100W at point E on indifference curve, I (see
Figure). Before tariff Pw/Pc = 1, this shows that price of wheat is equal to one (P w=1). Now,
suppose, if India imposes 100 per cent ad valorem tariff (fixed percentage on the value of a
commodity). After 100 per cent of ad valorem tariff on imported wheat, P w/Pc remains
unchanged at the free trade price of PA = 1 on the world market because the India is now
assumed to be a small nation. However, for individual producers and consumers in the India
price of wheat rises to the full amount of the tariff so that Pw rises to Rs.2. As a result, the price
line curve shifts from PA = 1 to PT = 2. At Pw/Pc = PT = 2, India produces 95C and 65W at point
T and consumes 65C and 95W at point R1 on indifference curve, III (shown by dashed line
indifference curve, which is tangent to the dashed parallel line. This dashed parallel line is
parallel to price line, PA 1). Student must observe the ATSRI, where India exports 30C (TS) for
30W (SR1). Out of 30W (SR1) 15W (SR = 80 - 65) goes directly to the Indian consumers and
the remaining 15W (RR1 = 95 80) is collected by the government as tariff revenue. however,
since the government collects tariff revenue and redistributes the tariff in the form of public
consumption and/or tax relief, indifference curve, III must also be on the dashed line parallel to
PA = 1(since the nation as a whole still faces the world price Pw/Pc = 1). Thus, the new
consumption point R1 is defined by the intersection of the two dashed lines (and therefore is on
both). The angle between the two dashed lines (which is equal to the angle between the price
lines PA = 1 and PT = 2) is equal to the tariff rate of 100 per cent. After tariff India’s
consumption at point R1 on indifference curve, III is inferior to India’s free trade consumption
point E on indifference curve, I because indifference curve, III lies below indifference curve, I.
However, real income of scarce factor in India (i.e., capital) rises. Real income of capital rises
because with the tariff India produces more and more unit of wheat, which employs more and
more capital. As a result, demand for capital increases interest on capital. The effect of general
equilibrium analysis of tariff in a small country can be summarised as follows:
1. With imposition of tariff by a small nation, prices of the world market remain unchanged.
2. Domestic price of the importable commodity will rise by the full amount of the tariff for
individual producers and consumers in a small nation.
3. Domestic production of the importable commodity rises, while domestic consumption and
import falls in the small nation.
4. The price of the importable commodity for the small nation as a whole remains unchanged
since the small nation itself collects the tariff.
5. The welfare of the small nation declines as consumption falls down, and
6. The real income of the nation’s scarce factors increases with the imposition of tariff This is
called the Stolper-Samuelson Theorem.
General Equilibrium Effects of a Tariff in a Large Country
When a large nation imposes a tariff, its offer curves shifts or rotates towards the axis measuring
its importable commodity by the amount of the import tariff. The reasons is that for any amount
of the export commodity, importers now want sufficiently more of the import commodity to
cover (or to pay for) the tariff. The fact that the nation is large is reflected in the trade partner’s
(or rest of the world’s) offer curve having some curvature rather than being a straight line.
The imposition of a tariff by a large nation improves its terms of trade but reduces the volume of
trade. The reduction in the volume of trade, by itself, tends to reduce the nation’s welfare, while
improvement in its terms of trade tends to increase the nation’s welfare. However, since the
improvement in the nation’s welfare comes at the expense of its trade partner, the trade partner is
likely to retaliate and, in the end, both nations usually lose. These effects are best analysed in the
Figure below. Whether the nation’s welfare actually rises or falls depends on the net effect of
these two opposing forces. If the positive effect on the nation’s welfare resulting from the better
terms of trade exceeds the negative effects from the reduced volume of trade, the nation’s
welfare will also be greater. The general equilibrium effect of a tariff in a large country is
explained in the Figure below, in which 0K and 0N are offer curves of U.K. and India
respectively. Quantity of cloth (QC) is shown on Y and quantity of wheat (QW) is shown on X
axis.
Assume that both India and the U.K. are large nations so that affect world prices. Under free
trade (i.e. before imposition of any tariff), the offer curves of India and the U.K. in Figure above
crosses each other at point E giving the equilibrium Pw/Pc = PE = 1, at which 60C are exchanged
for 60W. If the India imposes 100 per cent ad valorem tariff on wheat, offer curve of India
rotates down towards importable commodity i.e., wheat so that offer curve of India rotates down
to offer curve India 1, which is at all points twice as distant from the cloth axis as offer curve
India. This happens because with 100 per cent tariff on wheat import, the India now wants 100
per cent more, or twice as much, wheat as before for each quantity of cloth exported. After
imposition of the tariff, the intersection of offer curve India 1 and offer curve U.K. defined new
equilibrium point T, at which India exchanges 40C for 50W from the U.K at the new world price
(since nation is large world price has changed after imposition of tariff; this was not so in case of
small country, where world price remain unchanged after imposition of tariff) of P w/Pc = PT =
0.8.
Thus, the terms of trade of the U.K. (the rest of the world) deteriorated from Pw/Pc = PE = 1 to
Pw/Pc = PT = 0.8. on the other hand the nation India's terms of trade improved from P c/Pw= 1/ PE
= 1 to Pc/Pw= 1/ Pr = 1/0.8= 1.25 (since in a two nation world the imports of a nation are the
exports of its trade partner, the terms of the trade of the partner is the inverse or the reciprocal of
the terms of the trade of the other nation). Note that for any tariff rate, the steeper or less elastic
Nation U.K. (the rest of the world) offer curve is, the more its terms of trade deteriorate and
India's terms of trade improves. Thus, when a large nation India (as assumed) imposes a tariff,
the volume of trade deteriorates (before tariff India was exchanging 60C for 60W; after tariff it
has reduced to 40C for 50W) but India's (nation imposing tariff) terms of trade improves (before
tariff India’s terms of trade was PE = 1; after tariff it has improved to PT = 1/0.8 = 1.25).
Depending on the two opposing forces (i.e., terms of trade and volume of trade)
India’s welfare can increase, decrease, or remain unchanged. If the positive effect on the India’s
welfare resulting from the better terms of trade exceeds the negative effects from the reduced
volume of trade, the India’s welfare will also be greater. Student must note here that in case of a
small country nation’s welfare always declines with the imposition of the tariff.
After imposition of tariff by India, India is in equilibrium at point T by exchanging 40C for 50W
so that Pw/Pc = PT = 0.8 on the world market and for the India as a whole. However, of the 50W
imported by India at equilibrium point T, 25W is collected in king by the government of
India as the 100 per cent import tariff on wheat and only the remaining 25W goes directly to
individual consumers. As a result, for individual consumers and producers in India P w/Pc = PD =
1.6, or twice as much as the price of the world market and for the nation as a whole (PT = 0.8) as
shown in Figure above.
Since the relative price of the importable commodity wheat rises for individual consumer and
producers in India, the Stolper–Samuelson theorem also holds for the large nation India (and rate
of interest on capital (scarce factor in India) increases. Also to be pointed out is that the Stolper–
Samuelson theorem refers to the long run when all factors are mobile between the nation’s
industries. If one of the two factors (say, capital) is immobile (so that we are in the short run), the
effect of tariff on the factor’s income will differ from that postulated by the Stolper – Samuelson
theorem.
Starting from the free trade position, as the India imposes higher tariffs, the India’s welfare will
increase up to a point (the optimum tariff, the optimum tariff is that rate of tariff that maximises
the net benefit resulting from the improvement in the nation’s terms of trade against the negative
effect resulting from reduction in the volume of trade) and decline thereafter.
However, since the improved position of the India after the imposition of tariff on wheat comes
at the expense of the U.K., the U.K.is likely to retaliate. If the U.K. imposed a 100 per cent ad
valorem tariff on the cloth, the offer curve of the UK move from offer curve U.K. to offer curve
U.K. and cross offer curve India at point R on the same terms of trade PE = 1 but the volume of
trade worsen off. Then both nations India and the U.K. would be worse off than under free trade
2.13. Summary
A country need to balance its trade so that international trade does not become a burden for them.
Either surplus BoP or Equal BoP is considered to be good for any country. However due to
demands and supply the ration of import and export changes and country may face deficit BoP .
thus country adopt various methods to control the flows of goods and services into the country.
Tariff is one such method which is used by countries for a balanced growth
Key Points
1. Crypto currencies are digital financial assets, for which records and transfers of ownership are
guaranteed by a cryptographic technology rather than a bank or other trusted third party.
2. A tariff is a duty or tax imposed by the government of a country upon the traded commodity as
it crosses the national boundaries. Tariff can be levied both upon exports and imports.
3. Quota is a quantity limit. It restricts imports of commodities physically. It specifies the
maximum amount that can be imported during a given time period.
4. The nominal rate of protection is the percentage tariff imposed on a product as it enters the
country.
2.14. Check Your Progress
1. What are the consequences of BoP disequilibrium? Explain measures to control
Disequilibrium.
2. Critically examine the elasticity approach of balance of payments.
3. What is crypto currency? What is the future of crypto currency?
4. Discuss the nominal and effective rate of protection.
5. What is Tariff? Discuss the differences between Tariff and quota.
 UNIT-III
INTERNATIONAL TRADING ORGANISATIONS AND GLOBAL TRADING SYSTEM
Structure
3.0 Introduction
3.1 Unit Objective
3.2 World Trade and Theory of Regional Blocks
3.3 GATT and Trade Rounds,
3.4 Multilateral Trading System and the World Trade Organization (WTO) –
3.5 Trade and Environment,
3.6 Trade and Labour Standards
3.7 Theory of Custom Union
3.8 Static and Dynamic Effects of a Customs Union and Free Trade Areas;
3.9 Rationale and Economic Progress of
3.10 Summary
3.11 Answer to Check Your Progress
3.12 Check Your Progress
---------------------------------------------------------------------------------------------------------------------
3.0. Unit Objective
The objective of this unit is to look into the history of GATT, various rounds of GATT to
promote trade and the rationale behind formation of WTO. Gaze into the formation of WTO,
objectives, and its multi trading systems like TRIMS, TRIPS etc. It also enlighten the students
the formation, functions and the major economic development done by regional associations and
it role for developing countries in general and India in particular.
3.1. Introduction
World has become into a single market. Globalisation has integrated the world market.
International trade has become an essential part of all economies. A developed country wants
more trade but developing countries tries to protect their domestic market. Sometimes the
developing countries are even exploited. Thus the needs of organisations are felt that could
promote the trade around the globe and not just promote trade, it could protect the nations from
all types of exploitation. Thus WTO was formed. The countries also felt that that the regional
trade should also be promoted and there should be some methods by which the countries could
prosper by trading freely among themselves. Thus the regional associations like EU, ASEAN
and SAARC were formed.
3.2. WORLD TRADE AND THEORY OF REGIONAL BLOCKS
Since the 1960s, regional economic integration has been a goal pursued by most middle-income
countries. For some, it was a means to take advantage of geographical proximity to enlarged
markets.
Regional integration would allow economies to gain in terms of scale of production and in
moving up the value chain, through import substitution industrialization and without opening up
immediately to competition with the most advanced exporters in the world. That was the path
chosen by Latin American economies in the 1960s and 1970s. Later, in the 1980s, most Latin
American economies, in the face of a very severe fi nancial crisis, were induced through
International Monetary Fund (IMF) adjustment programs to unilaterally open their economies to
world trade; as a consequence, the process of regional integration received less attention.
East Asian economies, meanwhile, have pursued an export-driven development strategy at a
national level since the 1960s. With the support of their governments, a selected group of private
and public companies oriented their output toward external markets, seeking to create
international production and distribution networks. Cooperation among firms in a regional
context emerged as a natural process. The “de facto integration” at the firm level created shared
interests for influencing governments to move toward more formal associations, such as the
Association of Southeast Asian Nations (ASEAN). The opening up of the East Asian economies
was further advanced by the severe financial shock of the late 1990s and the consequent reforms
induced by the IMF and the World Bank.
For Eastern European middle-income economies, dramatic political changes such as the collapse
of the Soviet Union forced deep changes in the way they perceived their integration into the
world economy. After 1989, Eastern European countries rejected any association with the former
Soviet Union and sought to create an association among themselves, as a step toward full
accession to the (Western) European Union. The EU would, in turn, set the criteria these
countries would need to meet to be accepted as full members.
Thus, it is quite clear that while the three regions considered in this study all converged toward
opening up to trade and toward RTAs, they followed very different paths in getting there. Two
underlying common factors pushed in that direction: a decline in transport and communication
costs, and increased awareness of, and desire for, world-class consumer goods. The opportunity
to become a part of global production chains also was appealing. All these factors made
isolationism less viable.
Why worry about the fate of regional trade agreements now, when the main problems and
challenges seem to lie elsewhere? Before the current crisis, the implied strategy of middle-
income countries was that exports to developed economies’ markets would be the main engine of
growth. The assumptions were that the developed economies would continue exhibiting robust
growth and that multilateral trade negotiation would make their markets more accessible. Th is
presupposed a successful completion of the Doha Round. None of those assumptions seems
realistic anymore.
With multilateral negotiations dead, as in the Doha Round, the rationale for a greater role for
regional integration—as a stepping-stone toward global free trade—seems to be gaining ground
in most middle-income countries. If multilateralism is not achievable, then minilateralism, based
mostly on geography, might well provide an acceptable alternative.
Results so far for RTAs shows that Trade from Eastern European countries to the European
Union 27 has reached 79 percent of their total exports. But for Latin America—whose efforts at
regional integration started 50 years ago, at the same time as in Europe—intraregional trade in
2008 represented only 12 percent of the total. Differences in political and development strategies
in Latin America have introduced multiple constraints to a free trade area there.
3.3. GATT AND TRADE ROUNDS
The General Agreement on Tariffs and Trade (GATT), which was signed in 1947, is a
multilateral agreement regulating trade among 153 countries. According to its preamble, the
purpose of the GATT is the "substantial reduction of tariffs and other trade barriers and the
elimination of preferences, on a reciprocal and mutually advantageous basis."
The GATT functioned de facto as an organization, conducting eight rounds of talks addressing
various trade issues and resolving international trade disputes. The Uruguay Round, which was
completed on December 15, 1993 after seven years of negotiations, resulted in an agreement
among 117 countries (including the U.S.) to reduce trade barriers and to create more
comprehensive and enforceable world trade rules. The agreement coming out of this round, the
Final Act Embodying the Results of the Uruguay Round of Multilateral Trade Negotiations, was
signed in April 1994. The Uruguay Round agreement was approved and implemented by the
U.S. Congress in December 1994. and went into effect on January 1. This agreement also created
the World Trade Organization (WTO), which came intol being on January 1, 1995. The WTO
implements the agreement, provides a forum for negotiating additional reductions of trade
barriers and for settling policy disputes, and enforces trade rules. The WTO launched the ninth
round of multilateral trade negotiations under the "Doha Development Agenda" (DDA or Doha
Round) in 2001 1995.
3.1. Various Provisions under GATT:
1. The General Agreement on Tariffs and Trade 1994 ("GATT 1994") shall consist of
(a) The provisions in the General Agreement on Tariff's and Trade, dated 30 October 1947.
annexed to the Final Act Adopted at the Conclusion of the Second Session of the Preparatory
Committee of the United Nations Conference on Trade and Employment (excluding the Protocol
of Provisional Application), as rectified. amended or modified by the terms of legal instruments
which have entered into force before the date of entry into force of the WTO Agreement;
(b) The provisions of the legal instruments set forth below that have entered into force under the
GATT 1947 before the date of entry into force of the WTO Agreement:
(i) Protocols and certifications relating to tariff concessions;
(ii) Protocols of accession (excluding the provisions (a) concerning provisional application and
withdrawal of provisional application and (b) providing that Part II of GATT 1947 shall be
applied provisionally to the fullest extent not inconsistent with legislation existing on the date of
the Protocol);
(iii) Decisions on waivers granted under Article XXV of GATT 1947 and still in
force on the date of entry into force of the WTO Agreement
(iv) Other decisions of the CONTRACTING PARTIES to GATT 1947;
(c) The Understandings set forth below. (1) Understanding on the Interpretation of Article
11:1(b) of the General Agreement on Tariffs and Trade 1994;
(ii) Understanding on the Interpretation of Article XVII of the General Agreement on Tariffs and
Trade 1994;
(iii) Understanding on Balance-of-Payments Provisions of the General Agreement on
Tariffs and Trade 1994.
(iv) Understanding on the Interpretation of Article XXIV of the General Agreement
on Tariffs and Trade 1994:
(v) Understanding in Respect of Waivers of Obligations under the General Agreement on Tariffs
and Trade 1994,
(vi) Understanding on the Interpretation of Article XXVIII of the General Agreement on Tariffs
and Trade 1994;
(d) The Marrakesh Protocol to GATT 1994.
2. Explanatory Notes
(a) The references to "contracting party" in the provisions of GATT 1994 shall be deemed to
read "Member". The references to "less-developed contracting party" and developed contracting
party" shall be deemed to read "developing country Member" and "developed country Member".
The references to "Executive Secretary" shall be deemed to read "Director-General of the WTO".
(b) The references to the CONTRACTING PARTIES acting jointly in Articles XV:1, XV:2,
XV:8. XXXVIII and the Notes Ad Article XII and XVIII; and in the provisions on special
exchange agreements in Articles XV:2, XV:3, XV:6, XV:7 and XV:9 of GATT 1994 shall be
deemed to be references to the WTO. The other functions that the provisions of GATT 1994
assign to the CONTRACTING PARTIES acting jointly shall be allocated by the Ministerial
Conference.
(c) (i) The text of GATT 1994 shall be authentic in English, French and Spanish.
(ii) The text of GATT 1994 in the French language shall be subject to the rectifications of terms
indicated in Annex A to document MTN.TNC/41. (iii) The authentic text of GATT 1994 in the
Spanish language shall be the text in Volume IV of the Basic Instruments and Selected
Documents series, subject to the rectifications of terms indicated in Annex B to document
MTN.TNC/41
3. (a) The provisions of Part II of GATT 1994 shall not apply to measures taken by a Member
under specific mandatory legislation, enacted by that Member before it became a contracting
party to GATT 1947, that prohibits the use, sale or lease of foreign-built or foreign-reconstructed
vessels in commercial applications between points in national waters or the waters of an
exclusive economic zone. This exemption applies to: (a) the continuation or prompt renewal of a
non-conforming provision of such legislation; and (b) the amendment to a non-conforming
provision of such legislation to the extent that the amendment does not decrease the conformity
of the provision with Part II of GATT 1947. This exemption is limited to measures taken under
legislation described above that is notified and specified prior to the date of entry into force of
the WTO Agreement. If such legislation is subsequently modified to decrease its conformity with
Part II of GATT 1994, it will no longer qualify for coverage under this paragraph.
(b) The Ministerial Conference shall review this exemption not later than five years after the date
of entry into force of the WTO Agreement and thereafter every two years for as long as the
exemption is in force for the purpose of examining whether the conditions which created the
need for the exemption still prevail. (c) A Member whose measures are covered by this
exemption shall annually submit a detailed statistical notification consisting of a five-year
moving average of actual and expected deliveries of relevant vessels as well as additional
information on the use, sale. lease or repair of relevant vessels covered by this exemption. (d) A
Member that considers that this exemption operates in such a manner as to justify a reciprocal
and proportionate limitation on the use, sale, lease or repair of vessels constructed in the territory
of the Member invoking the exemption shall be free to introduce such a limitation subject to
prior notification to the Ministerial Conference. (e) This exemption is without prejudice to
solutions concerning specific aspects of the legislation covered by this exemption negotiated in
sect oral agreements or in other form.
3.2. Various Rounds of Negotiations: An Overview:
Annency Round - 1949
The second round took place in 1949 in France. 13 countries took part in the round. The main
focus of the talks was more tariff reductions, around 5000 in total.
Torquay Round - 1951
The third round occurred in Torquay, England in 1950. Thirty-eight countries took part in the
round: 8.700 tariff concessions were made totaling the remaining amount of tariffs to % of the
tariffs which were in effect in 1948. The contemporaneous rejection by the U.S. of the Havana
cahrter signified the establishment of the GATT as a governing world body
Geneva Round - 1955-1959
The fourth round returned to Geneva in 1955 and lasted until May 1956. Twenty-six countries
took part in the round. $2.5 billion in tariffs were eliminated or reduced.
Dillon Round 1960-1962
The fifth round occurred once more in Geneva and lasted from 1960-1962. The talks were named
after U.S. Treasury Secretary and former Under Secretary of State, Douglas, Dillon who first
proposed the talks. Twenty-six countries took part in the round. Along with reducing over $4.9
billion in tariffs, it also yielded discussion relating to the creation of the European Economic
Community.
Kennedy Round - 1962-1967
The sixth round of GATT multilateral trade negotiations, held from 1963 to 1967. It was named
after President John F Kennedy in recognition of his support for the reformulation of the United
States trade agenda, which resulted in the Trade Expansion Act of 1962. This Act gave the
President the widest-ever negotiating authority.
As the Dillon Round went through the laborious process of item-by-item tariff negotiations, it
became clear, long before the Round ended, that a more comprehensive approach was needed to
deal with the emerging challenges resulting from the formation of the European Economic
Community (EEC) and EFTA, as well as Europe's emergence as a significant international trader
more generally.
Japan's high economic growth rate portended the major role it would play later as an exporter,
but the focal point of the Kennedy Round always was the United States FLC relationship.
Indeed, there was an influential American view that saw what became the Kennedy Round as the
start of a transatlantic partnership that might ultimately lead to a transatlantic economic
community.
To an extent, this view was shared in Europe, but the process of European unification created its
own stresses under which the Kennedy Round at times became a secondary focus for the EFC.
An example of this was the French veto in January 1963, before the round had even started, on
membership by the United Kingdom.
Another was the internal crisis of 1965, which ended in the Luxembourg Compromise.
Preparations for the new round were immediately overshadowed by the Chicken War, an early
sign of the impact variable levies under the Common Agricultural Policy would eventually have.
Some participants in the Round had been concerned that the convening of UCTAD, scheduled
for 1964, would result in further complications, but its impact on the actual negotiations was
minimal.
In May 1963 Ministers reached agreement on three negotiating objectives round:
(a) Measures for the expansion of trade of developing counties as a means of furthering their
economic development,
(b) Reduction or elimination of tariffs and other barriers to trade, and
(c) Measures for access to markets for agricultural and other primary products. The working
hypothesis for the tariff negotiations was a linear tariff cut of 50% with the smallest number of
exceptions. A drawn-out argument developed about the trade effects a uniform linear cut would
have on the dispersed rates (low and high tariffs quite far apart) of the United States as compared
to the much more concentrated rates of the EEC which also tended to be in the lower held of
United States tariff rates.
The EEC accordingly argued for an evening-out or harmonization of peaks and troughs through
its cerement, double cart and thirty: ten proposals. Once negotiations had been joined, the lofty
working hypothesis was soon undermined. The special structure countries (Australia, Canada,
New Zealand and South Africa), so called because their exports were dominated by raw
materials and other primary commodities, negotiated their tariff reductions entirely through the
item-by-item method.
In the end, the result was an average 35% reduction in tariffs, except for textiles, chemicals, steel
and other sensitive products: plus a 15% to 18% reduction in tariffs for agricultural and food
products. In addition, the negotiations on chemicals led to aprovisional agreement on the
abolition of the American Selling Price (ASP). The was a method of valuing some chemicals
used by the noted States for the imposition of import duties which gave domestic manufacturers
a much higher level of protection than the tariff schedule indicated.
However, this part of the outcome was disallowed by Congress, and the American Selling Price
was not abolished until Congress adopted the results of the Tokyo Round The results on
agriculture overall were poor. The most notable achievement was agreement on a Memorandum
of Agreement on Basic Elements for the Negotiation of a World Grants Arrangement, which
eventually was rolled into a new International Grains Arrangement.
The EEC claimed that for it the main result of the negotiations on agriculture was that they
"greatly helped to define its own common policy". The developing countries, which played a
minor role throughout the negotiations in this Round, benefited nonetheless from substantial
tariff cuts particularly in non-agricultural items of interest to them.
Their main achievement at the time, however, was seen to be the adoption of Part IV of the
GATT, which absolved them from according reciprocity to developed countries in trade
negotiations. In the view of many developing countries, this was a direct result of the call at
UNCTAD I for a better trade deal for them.
There has been argument ever since whether this symbolic gesture was a victory for them, or
whether it ensured their exclusion in the future from meaningful participation in the multilateral
trading system. On the other hand, there was no doubt that the extension of the Long-Term
Arrangement Regarding International Trade in Cotton Textiles, which later became the Multi-
Fiber Arrangement, for three years until 1970 led to the longer-term impairment of export
opportunities for developing countries.
Another outcome of the Kennedy Round was the adoption of an Anti-dumping Code, which gave
more precise guidance on the implementation of Article VI of the GATT. In particular, it sought
to ensure speedy and fair investigations, and it imposed limits on the retrospective application of
anti-dumping measures. Kennedy Round took place from 1962-1967. $40 billion in tariffs were
eliminated or reduced.
Tokyo Round - 1973-1979
Reduced tariffs and established new regulations aimed at controlling the proliferation of non-
tariff barriers and voluntary export restrictions. 102 countries took part in the round Concessions
were made on $190 billion worth.
Uruguay Round - 1986
It began in 1986. It was the most ambitious round to date, hoping to expand the competence of
the GATT to important new areas such as services, capital, intellectual property, textiles and
agriculture. 123 countries took part in the round. The Uruguay Round was also the first set of
multilateral trade negotiations in which developing countries had played an active role.
Agriculture was essentially exempted from previous agreements as it was given special status in
the areas of import quotas and export subsidies, with only mild caveats. However, by the time of
the Uruguay round, many countries considered the exception of agriculture to be sufficiently
glaring that they refused to sign a new deal without some movement on agricultural products.
These fourteen countries came to be known as the Cairns group and included mostly small and
medium sized agricultural exporters such as Australia, Brazil, Canada, and Indonesia.
The Agreement on Agriculture of the Uruguay Round continues to be the most substantial trade
liberalization agreement in agricultural products in the history of trade negotiations. The goals of
the agreement were to improve market access for agricultural products, reduce domestic support
of agriculture in the form of price-distorting subsidies and quotas, and eliminate over time export
subsidies on agricultural products and to harmonize to the extent possible sanitary and
phytosanitary measures between member countries.
3.4. Multilateral Trading System and the World Trade Organization (WTO)
World Trade Organization (WTO) came into existence on January 1, 1995, as a result of the
Uruguay Round of Trade Negotiations. Various agreements arrived at during this negotiation
period (1986-1994), and popularly known as the Uruguay Round of agreements form the legal
framework for the functioning of the WTO. The WTO forms a legal and institutional framework
for the multilateral trading system. This is a definite improvement over the historical GATT,
which was only a legal agreement. The WTO thus provides a forum for the member countries to
interpret established international trade laws to settle the trade related disputes, and also to
initiate fresh negotiations among member countries in the Uruguay Round of trade negotiations.
Many subjects were taken up for discussion for the first time. Agriculture was one of them. The
Uruguay round of Agreement on Agriculture, later known as the WTO Agreement on
Agriculture, attempts to establish free and fair trade in agriculture.
Thus the Agreement which paved way for the establishment of the World Trade Organisation
(WTO) in place of General Agreement on Tariff and Trade (GATT) broadened the scope of
operations by bringing in services, intellectual property rights and several other trade related
issues into its fold. Each country, small or big or rich or poor, has one vote. Although
economically stronger nations will have a larger say in its functioning, at least theoretically, it is
a democratic organization. There is also a dispute settlement body, which dispenses justice in
trade disputes between countries. The most significant change between the GATT regime and
WTO regime is that while it was optional to join any particular agreement emanating from a
particular round of talks of GATT, a member country has to be a party to all the 29 agreements
negotiated in the Uruguay Round or else it has to leave the organisation. 4.1. MFN treatment
under WTO:
India is a founder Member of both GATT and the WTO. The WTO provides a rule based
transparent and predictable multilateral trading system. The WTO rules envisage non-
discrimination in the form of National Treatment and Most Favoured Nation (MFN) treatment to
India's exports in the markets of other WTO members.
National Treatment ensures that India's products once imported into the territory of other WTO
members would not be discriminated vis-a-vis the domestic products in those countries. MFN
treatments principle ensures that Members do not discriminate among various WTO Members. If
a member country believes that the due benefit are not accruing to it because of trade measures
by another WTO Member, which are violation of WTO rules and disciplines, it may file a
dispute under the Dispute Settlement Mechanism (DSM) of the WTO. There are also
contingency provisions built into WTO rules, enabling Member countries to take care of
exigencies like balance of payment problems and situations like a surge in imports. In case of
unfair trade practices causing injury to the domestic producers, there are provisions to impose
Anti-Dumping or countervailing duties as provided for in the Anti-Dumping Agreement and the
Subsidies and Countervailing Measures Agreement.
TRIMS
The Agreement on Trade-Related Investment Measures (TRIMS) recognizes that certain
investment measures can restrict and distort trade. It states that WTO members may not apply
any measure that discriminates against foreign products or that leads to quantitative restrictions,
both of which violate basic WTO principles. A list of prohibited TRIMS, such as local content
requirements, is part of the Agreement. The TRIMS Committee monitors the operation and
implementation of the Agreement and allows members the opportunity to consult on any relevant
matters.
This Agreement, negotiated during the Uruguay Round, applies only to measures that affect
trade in goods. Recognizing that certain investment measures can have trade-restrictive and
distorting effects, it states that no Member shall apply a measure that is prohibited by the
provisions of GATT Article III (national treatment) or Article XI (quantitative restrictions).
Objectives the TRIMS Agreement
The objectives of the Agreement, as defined in its preamble, include “the expansion and
progressive liberalization of world trade and to facilitate investment across international frontiers
so as to increase the economic growth of all trading partners, particularly developing country
members, while ensuring free competition”.
Limitation of Coverage to Trade in Goods back to top
The coverage of the Agreement is defined in Article 1, which states that the Agreement applies
to investment measures related to trade in goods only. Thus, the TRIMs Agreement does not
apply to services.
What is a “Trade-Related Investment Measure”?
The term “trade-related investment measures” (“TRIMs”) is not defined in the Agreement.
However, the Agreement contains in an annex an Illustrative List of measures that are
inconsistent with GATT Article III:4 or Article XI:1 of GATT 1994.
The TRIMs Agreement and Regulation of Foreign Investment
As an agreement that is based on existing GATT disciplines on trade in goods, the Agreement is
not concerned with the regulation of foreign investment. The disciplines of the TRIMs
Agreement focus on investment measures that infringe GATT Articles III and XI, in other words,
that discriminate between imported and exported products and/or create import or export
restrictions. For example, a local content requirement imposed in a non-discriminatory manner
on domestic and foreign enterprises is inconsistent with the TRIMs Agreement because it
involves discriminatory treatment of imported products in favour of domestic products. The fact
that there is no discrimination between domestic and foreign investors in the imposition of the
requirement is irrelevant under the TRIMs Agreement.
Basic Substantive Obligations: Article 2 and the Illustrative List
Article 2.1 of the TRIMs Agreement requires Members not to apply any TRIM that is
inconsistent with the provisions of Article III (national treatment of imported products) or Article
XI (prohibition of quantitative restrictions on imports or exports) of GATT 1994. An Illustrative
List annexed to the TRIMs Agreement lists measures that are inconsistent with paragraph 4 of
Article III and paragraph 1 of Article XI.
Mandatory and Non-mandatory Measures
The Illustrative List covers both TRIMs which are mandatory or enforceable under domestic law
or under administrative rulings and TRIMs compliance with which is necessary to obtain an
advantage.
Under Article 5.1 Members were required to notify to the Council for Trade in Goods, within 90
days after the date of entry into force of the WTO Agreement, any TRIMs that were not in
conformity with the Agreement. A decision adopted by the WTO General Council in April 1995
provided that governments that were not Members of the WTO on 1 January 1995, but were
entitled to become original Members within a period of two years after 1 January 1995, were to
notify under Article 5.1 within 90 days after the date of their acceptance of the WTO Agreement.
Countries that are not original Members of the WTO, in other words, newly acceding Members,
may be required to notify in accordance with any terms and conditions specified in their
Accession Protocols.
INTERNATIONAL TRADE IN SERVICES AND GATS
What is the main purpose of the GATS?
The creation of the GATS was one of the landmark achievements of the Uruguay Round, whose
results entered into force in January 1995. The GATS was inspired by essentially the same
objectives as its counterpart in merchandise trade, the General Agreement on Tariffs and Trade
(GATT): creating a credible and reliable system of international trade rules; ensuring fair and
equitable treatment of all participants (principle of non-discrimination); stimulating economic
activity through guaranteed policy bindings; and promoting trade and development through
progressive liberalization.
While services currently account for over two-thirds of global production and employment, they
represent no more than 25 per cent of total trade, when measured on a balance-of-payments
basis. This — seemingly modest — share should not be underestimated, however. Indeed,
balance-of-payments statistics do not capture one of the modes of service supply defined in the
GATS, which is the supply through commercial presence in another country (mode 3).
Furthermore, even though services are increasingly traded in their own right, they also serve as
crucial inputs into the production of goods and, consequently, when assessed in value-added
terms, services account for about 50 per cent of world trade.
Members of GATS
All WTO members are at the same time members of the GATS and, to varying degrees, have
assumed commitments in individual service sectors.
Modes of Supply
The GATS applies in principle to all service sectors, with two exceptions.
Article I (3) of the GATS excludes “services supplied in the exercise of governmental authority”.
These are services that are supplied neither on a commercial basis nor in competition with other
suppliers. Cases in point are social security schemes and any other public service, such as health
or education, that is provided at non-market conditions.
Furthermore, the Annex on Air Transport Services exempts from coverage measures affecting air
traffic rights and services directly related to the exercise of such rights.
The GATS distinguishes between four modes of supplying services: cross-border trade,
consumption abroad, commercial presence, and presence of natural persons.
Cross-border supply is defined to cover services flows from the territory of one member into
the territory of another member (e.g. banking or architectural services transmitted via
telecommunications or mail);
Consumption abroad refers to situations where a service consumer (e.g. tourist or patient)
moves into another member's territory to obtain a service;
Commercial presence implies that a service supplier of one member establishes a territorial
presence, including through ownership or lease of premises, in another member's territory to
provide a service (e.g. domestic subsidiaries of foreign insurance companies or hotel chains); and
Presence of natural persons consists of persons of one member entering the territory of another
member to supply a service (e.g. accountants, doctors or teachers). The Annex on Movement of
Natural Persons specifies, however, that members remain free to operate measures regarding
citizenship, residence or access to the employment market on a permanent basis.
The supply of many services often involves the simultaneous physical presence of both producer
and consumer. There are thus many instances in which, in order to be commercially meaningful,
trade commitments must extend to cross-border movements of the consumer, the establishment
of a commercial presence within a market, or the temporary movement of the service provider.
The GATS expressly recognizes the right of members to regulate the supply of services in
pursuit of their own policy objectives. However, the Agreement contains provisions ensuring that
services regulations are administered in a reasonable, objective and impartial manner.
Basic Obligations under the GATS?
Obligations contained in the GATS may be categorized into two broad groups: general
obligations that apply to all members and services sectors, as well as obligations that apply only
to the sectors inscribed in a member's schedule of commitments. Such commitments are laid
down in individual schedules whose scope may vary widely between members. The relevant
terms and concepts are similar, but not necessarily identical to those used in the GATT; for
example, national treatment is a general obligation in goods trade and not negotiable as under the
GATS.
(a) General obligations
MFN treatment: Under Article II of the GATS, members are held to extend immediately and
unconditionally to services or services suppliers of all other members “treatment no less
favourable than that accorded to like services and services suppliers of any other country”. This
amounts to a prohibition, in principle, of preferential arrangements among groups of members in
individual sectors or of reciprocity provisions which confine access benefits to trading partners
granting similar treatment.
Derogations are possible in the form of so-called Article II-exemptions. Members were allowed
to seek such exemptions before the Agreement entered into force. New exemptions can only be
granted to new members at the time of accession or, in the case of current members, by way of a
waiver under Article IX:3 of the WTO Agreement. All exemptions are subject to review; they
should in principle not last longer than 10 years. Furthermore, the GATS allows groups of
members to enter into economic integration agreements or to mutually recognize regulatory
standards, certificates and the like if certain conditions are met.
Transparency: GATS members are required, among other things, to publish all measures of
general application and establish national enquiry points mandated to respond to other members'
information requests.
Other generally applicable obligations include the establishment of administrative review and
appeals procedures and disciplines on the operation of monopolies and exclusive suppliers.
(b) Specific commitments
Market access: Market access is a negotiated commitment in specified sectors. It may be made
subject to various types of limitations that are enumerated in Article XVI(2). For example,
limitations may be imposed on the number of services suppliers, service operations or employees
in the sector; the value of transactions; the legal form of the service supplier; or the participation
of foreign capital.
National treatment: A commitment to national treatment implies that the member concerned
does not operate discriminatory measures benefiting domestic services or service suppliers. The
key requirement is not to modify, in law or in fact, the conditions of competition in favour of the
member's own service industry. Again, the extension of national treatment in any particular
sector may be made subject to conditions and qualifications.
Members are free to tailor the sector coverage and substantive content of such commitments as
they see fit. The commitments thus tend to reflect national policy objectives and constraints,
overall and in individual sectors. While some members have scheduled less than a handful of
services, others have assumed market access and national treatment disciplines in over 120 out of
a total of 160-odd services.
The existence of specific commitments triggers further obligations concerning, among other
things, the notification of new measures that have a significant impact on trade and the avoidance
of restrictions on international payments and transfers.
Schedule
Each WTO member is required to have a Schedule of Specific Commitments which identifies the
services for which the member guarantees market access and national treatment and any
limitations that may be attached. The Schedule may also be used to assume additional
commitments regarding, for example, the implementation of specified standards or regulatory
principles. Commitments are undertaken with respect to each of the four different modes of
service supply.
Most schedules consist of both sectoral and horizontal sections. The “Horizontal Section”
contains entries that apply across all sectors subsequently listed in the schedule. Horizontal
limitations often refer to a particular mode of supply, notably commercial presence and the
presence of natural persons. The “Sector-Specific Sections” contain entries that apply only to the
particular service.
TRIPS
The TRIPS Agreement, which came into effect on 1 January 1995, is to date the most
comprehensive multilateral agreement on intellectual property.
The areas of intellectual property that it covers are: copyright and related rights (i.e. the rights of
performers, producers of sound recordings and broadcasting organizations); trademarks
including service marks; geographical indications including appellations of origin; industrial
designs; patents including the protection of new varieties of plants; the layout-designs of
integrated circuits; and undisclosed information including trade secrets and test data.
The three main features of the Agreement are:
1. Standards: In respect of each of the main areas of intellectual property covered by the TRIPS
Agreement, the Agreement sets out the minimum standards of protection to be provided by each
Member. Each of the main elements of protection is defined, namely the subject-matter to be
protected, the rights to be conferred and permissible exceptions to those rights, and the minimum
duration of protection. The Agreement sets these standards by requiring, first, that the
substantive obligations of the main conventions of the WIPO, the Paris Convention for the
Protection of Industrial Property (Paris Convention) and the Berne Convention for the Protection
of Literary and Artistic Works (Berne Convention) in their most recent versions, must be
complied with. With the exception of the provisions of the Berne Convention on moral rights, all
the main substantive provisions of these conventions are incorporated by reference and thus
become obligations under the TRIPS Agreement between TRIPS Member countries. The
relevant provisions are to be found in Articles 2.1 and 9.1 of the TRIPS Agreement, which relate,
respectively, to the Paris Convention and to the Berne Convention. Secondly, the TRIPS
Agreement adds a substantial number of additional obligations on matters where the pre-existing
conventions are silent or were seen as being inadequate. The TRIPS Agreement is thus
sometimes referred to as a Berne and Paris-plus agreement.
2. Enforcement: The second main set of provisions deals with domestic procedures and
remedies for the enforcement of intellectual property rights. The Agreement lays down certain
general principles applicable to all IPR enforcement procedures. In addition, it contains
provisions on civil and administrative procedures and remedies, provisional measures, special
requirements related to border measures and criminal procedures, which specify, in a certain
amount of detail, the procedures and remedies that must be available so that right holders can
effectively enforce their rights.
3. Dispute settlement: The Agreement makes disputes between WTO Members about the
respect of the TRIPS obligations subject to the WTO's dispute settlement procedures.
In addition the Agreement provides for certain basic principles, such as national and most-
favoured-nation treatment, and some general rules to ensure that procedural difficulties in
acquiring or maintaining IPRs do not nullify the substantive benefits that should flow from the
Agreement. The obligations under the Agreement will apply equally to all Member countries, but
developing countries will have a longer period to phase them in. Special transition arrangements
operate in the situation where a developing country does not presently provide product patent
protection in the area of pharmaceuticals.
The TRIPS Agreement is a minimum standards agreement, which allows Members to provide
more extensive protection of intellectual property if they so wish. Members are left free to
determine the appropriate method of implementing the provisions of the Agreement within their
own legal system and practice.
Certain General Provisions
As in the main pre-existing intellectual property conventions, the basic obligation on each
Member country is to accord the treatment in regard to the protection of intellectual property
provided for under the Agreement to the persons of other Members. Article 1.3 defines who
these persons are. These persons are referred to as “nationals” but include persons, natural or
legal, who have a close attachment to other Members without necessarily being nationals. The
criteria for determining which persons must thus benefit from the treatment provided for under
the Agreement are those laid down for this purpose in the main pre-existing intellectual property
conventions of WIPO, applied of course with respect to all WTO Members whether or not they
are party to those conventions. These conventions are the Paris Convention, the Berne
Convention, International Convention for the Protection of Performers, Producers of
Phonograms and Broadcasting Organizations (Rome Convention), and the Treaty on Intellectual
Property in Respect of Integrated Circuits (IPIC Treaty).
Articles 3, 4 and 5 include the fundamental rules on national and most-favoured-nation treatment
of foreign nationals, which are common to all categories of intellectual property covered by the
Agreement. These obligations cover not only the substantive standards of protection but also
matters affecting the availability, acquisition, scope, maintenance and enforcement of intellectual
property rights as well as those matters affecting the use of intellectual property rights
specifically addressed in the Agreement. While the national treatment clause forbids
discrimination between a Member's own nationals and the nationals of other Members, the most-
favoured-nation treatment clause forbids discrimination between the nationals of other Members.
In respect of the national treatment obligation, the exceptions allowed under the pre-existing
intellectual property conventions of WIPO are also allowed under TRIPS. Where these
exceptions allow material reciprocity, a consequential exception to MFN treatment is also
permitted (e.g. comparison of terms for copyright protection in excess of the minimum term
required by the TRIPS Agreement as provided under Article 7(8) of the Berne Convention as
incorporated into the TRIPS Agreement). Certain other limited exceptions to the MFN obligation
are also provided for.
The general goals of the TRIPS Agreement are contained in the Preamble of the Agreement,
which reproduces the basic Uruguay Round negotiating objectives established in the TRIPS area
by the 1986 Punta del Este Declaration and the 1988/89 Mid-Term Review. These objectives
include the reduction of distortions and impediments to international trade, promotion of
effective and adequate protection of intellectual property rights, and ensuring that measures and
procedures to enforce intellectual property rights do not themselves become barriers to legitimate
trade. These objectives should be read in conjunction with Article 7, entitled “Objectives”,
according to which the protection and enforcement of intellectual property rights should
contribute to the promotion of technological innovation and to the transfer and dissemination of
technology, to the mutual advantage of producers and users of technological knowledge and in a
manner conducive to social and economic welfare, and to a balance of rights and obligations.
Article 8, entitled “Principles”, recognizes the rights of Members to adopt measures for public
health and other public interest reasons and to prevent the abuse of intellectual property rights,
provided that such measures are consistent with the provisions of the TRIPS Agreement.
Substantive Standards of Protection
Copyright
During the Uruguay Round negotiations, it was recognized that the Berne Convention already,
for the most part, provided adequate basic standards of copyright protection. Thus it was agreed
that the point of departure should be the existing level of protection under the latest Act, the Paris
Act of 1971, of that Convention. The point of departure is expressed in Article 9.1 under which
Members are obliged to comply with the substantive provisions of the Paris Act of 1971 of the
Berne Convention, i.e. Articles 1 through 21 of the Berne Convention (1971) and the Appendix
thereto. However, Members do not have rights or obligations under the TRIPS Agreement in
respect of the rights conferred under Article 6bis of that Convention, i.e. the moral rights (the
right to claim authorship and to object to any derogatory action in relation to a work, which
would be prejudicial to the author's honour or reputation), or of the rights derived therefrom. The
provisions of the Berne Convention referred to deal with questions such as subject-matter to be
protected, minimum term of protection, and rights to be conferred and permissible limitations to
those rights. The Appendix allows developing countries, under certain conditions, to make some
limitations to the right of translation and the right of reproduction.
In addition to requiring compliance with the basic standards of the Berne Convention, the TRIPS
Agreement clarifies and adds certain specific points.
Article 9.2 confirms that copyright protection shall extend to expressions and not to ideas,
procedures, methods of operation or mathematical concepts as such.
Article 10.1 provides that computer programs, whether in source or object code, shall be
protected as literary works under the Berne Convention (1971). This provision confirms that
computer programs must be protected under copyright and that those provisions of the Berne
Convention that apply to literary works shall be applied also to them. It confirms further, that the
form in which a program is, whether in source or object code, does not affect the protection. The
obligation to protect computer programs as literary works means e.g. that only those limitations
that are applicable to literary works may be applied to computer programs. It also confirms that
the general term of protection of 50 years applies to computer programs. Possible shorter terms
applicable to photographic works and works of applied art may not be applied.
Article 10.2 clarifies that databases and other compilations of data or other material shall be
protected as such under copyright even where the databases include data that as such are not
protected under copyright. Databases are eligible for copyright protection provided that they by
reason of the selection or arrangement of their contents constitute intellectual creations. The
provision also confirms that databases have to be protected regardless of which form they are in,
whether machine readable or other form. Furthermore, the provision clarifies that such protection
shall not extend to the data or material itself, and that it shall be without prejudice to any
copyright subsisting in the data or material itself.
Article 11 provides that authors shall have in respect of at least computer programs and, in
certain circumstances, of cinematographic works the right to authorize or to prohibit the
commercial rental to the public of originals or copies of their copyright works. With respect to
cinematographic works, the exclusive rental right is subject to the so-called impairment test: a
Member is excepted from the obligation unless such rental has led to widespread copying of such
works which is materially impairing the exclusive right of reproduction conferred in that
Member on authors and their successors in title. In respect of computer programs, the obligation
does not apply to rentals where the program itself is not the essential object of the rental.
According to the general rule contained in Article 7(1) of the Berne Convention as incorporated
into the TRIPS Agreement, the term of protection shall be the life of the author and 50 years
after his death. Paragraphs 2 through 4 of that Article specifically allow shorter terms in certain
cases. These provisions are supplemented by Article 12 of the TRIPS Agreement, which
provides that whenever the term of protection of a work, other than a photographic work or a
work of applied art, is calculated on a basis other than the life of a natural person, such term shall
be no less than 50 years from the end of the calendar year of authorized publication, or, failing
such authorized publication within 50 years from the making of the work, 50 years from the end
of the calendar year of making.
Article 13 requires Members to confine limitations or exceptions to exclusive rights to certain
special cases which do not conflict with a normal exploitation of the work and do not
unreasonably prejudice the legitimate interests of the right holder. This is a horizontal provision
that applies to all limitations and exceptions permitted under the provisions of the Berne
Convention and the Appendix thereto as incorporated into the TRIPS Agreement. The
application of these limitations is permitted also under the TRIPS Agreement, but the provision
makes it clear that they must be applied in a manner that does not prejudice the legitimate
interests of the right holder.
Related Rights
The provisions on protection of performers, producers of phonograms and broadcasting
organizations are included in Article 14. According to Article 14.1, performers shall have the
possibility of preventing the unauthorized fixation of their performance on a phonogram (e.g. the
recording of a live musical performance). The fixation right covers only aural, not audiovisual
fixations. Performers must also be in position to prevent the reproduction of such fixations. They
shall also have the possibility of preventing the unauthorized broadcasting by wireless means and
the communication to the public of their live performance.
In accordance with Article 14.2, Members have to grant producers of phonograms an exclusive
reproduction right. In addition to this, they have to grant, in accordance with Article 14.4, an
exclusive rental right at least to producers of phonograms. The provisions on rental rights apply
also to any other right holders in phonograms as determined in national law. This right has the
same scope as the rental right in respect of computer programs. Therefore it is not subject to the
impairment test as in respect of cinematographic works. However, it is limited by a so-called
grand-fathering clause, according to which a Member, which on 15 April 1994, i.e. the date of
the signature of the Marrakesh Agreement, had in force a system of equitable remuneration of
right holders in respect of the rental of phonograms, may maintain such system provided that the
commercial rental of phonograms is not giving rise to the material impairment of the exclusive
rights of reproduction of right holders.
Broadcasting organizations shall have, in accordance with Article 14.3, the right to prohibit the
unauthorized fixation, the reproduction of fixations, and the rebroadcasting by wireless means of
broadcasts, as well as the communication to the public of their television broadcasts. However, it
is not necessary to grant such rights to broadcasting organizations, if owners of copyright in the
subject-matter of broadcasts are provided with the possibility of preventing these acts, subject to
the provisions of the Berne Convention.
The term of protection is at least 50 years for performers and producers of phonograms, and 20
years for broadcasting organizations (Article 14.5).
Article 14.6 provides that any Member may, in relation to the protection of performers,
producers of phonograms and broadcasting organizations, provide for conditions, limitations,
exceptions and reservations to the extent permitted by the Rome Convention.
Trademarks
The basic rule contained in Article 15 is that any sign, or any combination of signs, capable of
distinguishing the goods and services of one undertaking from those of other undertakings, must
be eligible for registration as a trademark, provided that it is visually perceptible. Such signs, in
particular words including personal names, letters, numerals, figurative elements and
combinations of colours as well as any combination of such signs, must be eligible for
registration as trademarks.
Where signs are not inherently capable of distinguishing the relevant goods or services, Member
countries are allowed to require, as an additional condition for eligibility for registration as a
trademark, that distinctiveness has been acquired through use. Members are free to determine
whether to allow the registration of signs that are not visually perceptible (e.g. sound or smell
marks).
Members may make registrability depend on use. However, actual use of a trademark shall not
be permitted as a condition for filing an application for registration, and at least three years must
have passed after that filing date before failure to realize an intent to use is allowed as the ground
for refusing the application (Article 14.3).
The Agreement requires service marks to be protected in the same way as marks distinguishing
goods (see e.g. Articles 15.1, 16.2 and 62.3).
The owner of a registered trademark must be granted the exclusive right to prevent all third
parties not having the owner's consent from using in the course of trade identical or similar signs
for goods or services which are identical or similar to those in respect of which the trademark is
registered where such use would result in a likelihood of confusion. In case of the use of an
identical sign for identical goods or services, a likelihood of confusion must be presumed
(Article 16.1).
The TRIPS Agreement contains certain provisions on well-known marks, which supplement the
protection required by Article 6bis of the Paris Convention, as incorporated by reference into the
TRIPS Agreement, which obliges Members to refuse or to cancel the registration, and to prohibit
the use of a mark conflicting with a mark which is well known. First, the provisions of that
Article must be applied also to services. Second, it is required that knowledge in the relevant
sector of the public acquired not only as a result of the use of the mark but also by other means,
including as a result of its promotion, be taken into account. Furthermore, the protection of
registered well-known marks must extend to goods or services which are not similar to those in
respect of which the trademark has been registered, provided that its use would indicate a
connection between those goods or services and the owner of the registered trademark, and the
interests of the owner are likely to be damaged by such use (Articles 16.2 and 3).
Members may provide limited exceptions to the rights conferred by a trademark, such as fair use
of descriptive terms, provided that such exceptions take account of the legitimate interests of the
owner of the trademark and of third parties (Article 17).
Initial registration, and each renewal of registration, of a trademark shall be for a term of no less
than seven years. The registration of a trademark shall be renewable indefinitely (Article 18).
Cancellation of a mark on the grounds of non-use cannot take place before three years of
uninterrupted non-use has elapsed unless valid reasons based on the existence of obstacles to
such use are shown by the trademark owner. Circumstances arising independently of the will of
the owner of the trademark, such as import restrictions or other government restrictions, shall be
recognized as valid reasons of non-use. Use of a trademark by another person, when subject to
the control of its owner, must be recognized as use of the trademark for the purpose of
maintaining the registration (Article 19).
It is further required that use of the trademark in the course of trade shall not be unjustifiably
encumbered by special requirements, such as use with another trademark, use in a special form,
or use in a manner detrimental to its capability to distinguish the goods or services (Article 20).
Geographical Indications
Geographical indications are defined, for the purposes of the Agreement, as indications which
identify a good as originating in the territory of a Member, or a region or locality in that territory,
where a given quality, reputation or other characteristic of the good is essentially attributable to
its geographical origin (Article 22.1). Thus, this definition specifies that the quality, reputation or
other characteristics of a good can each be a sufficient basis for eligibility as a geographical
indication, where they are essentially attributable to the geographical origin of the good.
In respect of all geographical indications, interested parties must have legal means to prevent use
of indications which mislead the public as to the geographical origin of the good, and use which
constitutes an act of unfair competition within the meaning of Article 10bis of the Paris
Convention (Article 22.2).
The registration of a trademark which uses a geographical indication in a way that misleads the
public as to the true place of origin must be refused or invalidated ex officio if the legislation so
permits or at the request of an interested party (Article 22.3).
Article 23 provides that interested parties must have the legal means to prevent the use of a
geographical indication identifying wines for wines not originating in the place indicated by the
geographical indication. This applies even where the public is not being misled, there is no unfair
competition and the true origin of the good is indicated or the geographical indication is
accompanied be expressions such as “kind”, “type”, “style”, “imitation” or the like. Similar
protection must be given to geographical indications identifying spirits when used on spirits.
Protection against registration of a trademark must be provided accordingly.
Article 24 contains a number of exceptions to the protection of geographical indications. These
exceptions are of particular relevance in respect of the additional protection for geographical
indications for wines and spirits. For example, Members are not obliged to bring a geographical
indication under protection, where it has become a generic term for describing the product in
question (paragraph 6). Measures to implement these provisions shall not prejudice prior
trademark rights that have been acquired in good faith (paragraph 5). Under certain
circumstances, continued use of a geographical indication for wines or spirits may be allowed on
a scale and nature as before (paragraph 4). Members availing themselves of the use of these
exceptions must be willing to enter into negotiations about their continued application to
individual geographical indications (paragraph 1). The exceptions cannot be used to diminish the
protection of geographical indications that existed prior to the entry into force of the TRIPS
Agreement (paragraph 3). The TRIPS Council shall keep under review the application of the
provisions on the protection of geographical indications (paragraph 2).
Industrial Designs
Article 25.1 of the TRIPS Agreement obliges Members to provide for the protection of
independently created industrial designs that are new or original. Members may provide that
designs are not new or original if they do not significantly differ from known designs or
combinations of known design features. Members may provide that such protection shall not
extend to designs dictated essentially by technical or functional considerations.
Article 25.2 contains a special provision aimed at taking into account the short life cycle and
sheer number of new designs in the textile sector: requirements for securing protection of such
designs, in particular in regard to any cost, examination or publication, must not unreasonably
impair the opportunity to seek and obtain such protection. Members are free to meet this
obligation through industrial design law or through copyright law.
Article 26.1 requires Members to grant the owner of a protected industrial design the right to
prevent third parties not having the owner's consent from making, selling or importing articles
bearing or embodying a design which is a copy, or substantially a copy, of the protected design,
when such acts are undertaken for commercial purposes.
Article 26.2 allows Members to provide limited exceptions to the protection of industrial
designs, provided that such exceptions do not unreasonably conflict with the normal exploitation
of protected industrial designs and do not unreasonably prejudice the legitimate interests of the
owner of the protected design, taking account of the legitimate interests of third parties.
The duration of protection available shall amount to at least 10 years (Article 26.3). The wording
“amount to” allows the term to be divided into, for example, two periods of five years.
Patents
The TRIPS Agreement requires Member countries to make patents available for any inventions,
whether products or processes, in all fields of technology without discrimination, subject to the
normal tests of novelty, inventiveness and industrial applicability. It is also required that patents
be available and patent rights enjoyable without discrimination as to the place of invention and
whether products are imported or locally produced (Article 27.1).
There are three permissible exceptions to the basic rule on patentability. One is for inventions
contrary to ordre public or morality; this explicitly includes inventions dangerous to human,
animal or plant life or health or seriously prejudicial to the environment. The use of this
exception is subject to the condition that the commercial exploitation of the invention must also
be prevented and this prevention must be necessary for the protection of ordre public or morality
(Article 27.2).
The second exception is that Members may exclude from patentability diagnostic, therapeutic
and surgical methods for the treatment of humans or animals (Article 27.3(a)).
The third is that Members may exclude plants and animals other than micro-organisms and
essentially biological processes for the production of plants or animals other than non-biological
and microbiological processes. However, any country excluding plant varieties from patent
protection must provide an effective sui generis system of protection. Moreover, the whole
provision is subject to review four years after entry into force of the Agreement (Article 27.3(b)).
The exclusive rights that must be conferred by a product patent are the ones of making, using,
offering for sale, selling, and importing for these purposes. Process patent protection must give
rights not only over use of the process but also over products obtained directly by the process.
Patent owners shall also have the right to assign, or transfer by succession, the patent and to
conclude licensing contracts (Article 28).
Members may provide limited exceptions to the exclusive rights conferred by a patent, provided
that such exceptions do not unreasonably conflict with a normal exploitation of the patent and do
not unreasonably prejudice the legitimate interests of the patent owner, taking account of the
legitimate interests of third parties (Article 30).
The term of protection available shall not end before the expiration of a period of 20 years
counted from the filing date (Article 33).
Members shall require that an applicant for a patent shall disclose the invention in a manner
sufficiently clear and complete for the invention to be carried out by a person skilled in the art
and may require the applicant to indicate the best mode for carrying out the invention known to
the inventor at the filing date or, where priority is claimed, at the priority date of the application
(Article 29.1).
If the subject-matter of a patent is a process for obtaining a product, the judicial authorities shall
have the authority to order the defendant to prove that the process to obtain an identical product
is different from the patented process, where certain conditions indicating a likelihood that the
protected process was used are met (Article 34).
Compulsory licensing and government use without the authorization of the right holder are
allowed, but are made subject to conditions aimed at protecting the legitimate interests of the
right holder. The conditions are mainly contained in Article 31. These include the obligation, as a
general rule, to grant such licences only if an unsuccessful attempt has been made to acquire a
voluntary licence on reasonable terms and conditions within a reasonable period of time; the
requirement to pay adequate remuneration in the circumstances of each case, taking into account
the economic value of the licence; and a requirement that decisions be subject to judicial or other
independent review by a distinct higher authority. Certain of these conditions are relaxed where
compulsory licences are employed to remedy practices that have been established as
anticompetitive by a legal process. These conditions should be read together with the related
provisions of Article 27.1, which require that patent rights shall be enjoyable without
discrimination as to the field of technology, and whether products are imported or locally
produced.
Layout-Designs of Integrated Circuits
Article 35 of the TRIPS Agreement requires Member countries to protect the layout-designs of
integrated circuits in accordance with the provisions of the IPIC Treaty (the Treaty on
Intellectual Property in Respect of Integrated Circuits), negotiated under the auspices of WIPO in
1989. These provisions deal with, inter alia, the definitions of “integrated circuit” and “layout-
design (topography)”, requirements for protection, exclusive rights, and limitations, as well as
exploitation, registration and disclosure. An “integrated circuit” means a product, in its final
form or an intermediate form, in which the elements, at least one of which is an active element,
and some or all of the interconnections are integrally formed in and/or on a piece of material and
which is intended to perform an electronic function. A “layout-design (topography)” is defined
as the three-dimensional disposition, however expressed, of the elements, at least one of which is
an active element, and of some or all of the interconnections of an integrated circuit, or such a
three-dimensional disposition prepared for an integrated circuit intended for manufacture. The
obligation to protect layout-designs applies to such layout-designs that are original in the sense
that they are the result of their creators' own intellectual effort and are not commonplace among
creators of layout-designs and manufacturers of integrated circuits at the time of their creation.
The exclusive rights include the right of reproduction and the right of importation, sale and other
distribution for commercial purposes. Certain limitations to these rights are provided for.
In addition to requiring Member countries to protect the layout-designs of integrated circuits in
accordance with the provisions of the IPIC Treaty, the TRIPS Agreement clarifies and/or builds
on four points. These points relate to the term of protection (ten years instead of eight, Article
38), the applicability of the protection to articles containing infringing integrated circuits (last
sub clause of Article 36) and the treatment of innocent infringers (Article 37.1). The conditions
in Article 31 of the TRIPS Agreement apply mutatis mutandis to compulsory or non-voluntary
licensing of a layout-design or to its use by or for the government without the authorization of
the right holder, instead of the provisions of the IPIC Treaty on compulsory licensing (Article
37.2).
Protection of Undisclosed Information
The TRIPS Agreement requires undisclosed information -- trade secrets or know-how -- to
benefit from protection. According to Article 39.2, the protection must apply to information that
is secret, that has commercial value because it is secret and that has been subject to reasonable
steps to keep it secret. The Agreement does not require undisclosed information to be treated as a
form of property, but it does require that a person lawfully in control of such information must
have the possibility of preventing it from being disclosed to, acquired by, or used by others
without his or her consent in a manner contrary to honest commercial practices. “Manner
contrary to honest commercial practices” includes breach of contract, breach of confidence and
inducement to breach, as well as the acquisition of undisclosed information by third parties who
knew, or were grossly negligent in failing to know, that such practices were involved in the
acquisition.

The Agreement also contains provisions on undisclosed test data and other data whose
submission is required by governments as a condition of approving the marketing of
pharmaceutical or agricultural chemical products which use new chemical entities. In such a
situation the Member government concerned must protect the data against unfair commercial
use. In addition, Members must protect such data against disclosure, except where necessary to
protect the public, or unless steps are taken to ensure that the data are protected against unfair
commercial use.
Control of Anti-Competitive Practices in Contractual Licences
Article 40 of the TRIPS Agreement recognizes that some licensing practices or conditions
pertaining to intellectual property rights which restrain competition may have adverse effects on
trade and may impede the transfer and dissemination of technology (paragraph 1). Member
countries may adopt, consistently with the other provisions of the Agreement, appropriate
measures to prevent or control practices in the licensing of intellectual property rights which are
abusive and anti-competitive (paragraph 2). The Agreement provides for a mechanism whereby a
country seeking to take action against such practices involving the companies of another
Member country can enter into consultations with that other Member and exchange publicly
available non-confidential information of relevance to the matter in question and of other
information available to that Member, subject to domestic law and to the conclusion of mutually
satisfactory agreements concerning the safeguarding of its confidentiality by the requesting
Member (paragraph 3). Similarly, a country whose companies are subject to such action in
another Member can enter into consultations with that Member (paragraph 4).
3.5. TRADE AND ENVIRONMENT
Globalisation, specially the rapid growth of global trade, has put excessive stress on the world’s
environment. The use of energy required to move ever great quantities of goods around the world
has put stress on the environment.
The global competitive pressures induced by trade have put further stress on the environment.
The WTO has put stress on the environment. Further stress has been put by the opening up of
access to all the world’s farms, forests, rivers and wild life by more and more powerful
transnational corporations (TNC)
The Pollution Effect of Global Trade:
Expansion of world trade depends on oil. Since the burning of oil generate pollution, trade
produces pollution. Growth of both global trade and transport depends on oil and the pollution
effect of this is staggering.
Carbon, the major global warming agent, is the major pollutant emitted by the burning of oil,
Trade and transport have been major contribution to the sharp rise in carbon emission. Trade has
an enormous pollution cost and has an adverse effect on the environment.
Carbon emission contributes to “the Greenhouse Effect”. As a result world temperature had
risen in the past and are likely to rise in future. Aircraft emissions of nitrogen oxides produce
greenhouse gas. And nitrogen oxides produced by aircraft causes acid rain.
Shipping uses a low grade type of fuel that produces nitric oxide and nitrogen dioxide, which can
cause acid rain and photo-chemical smog. Shipping also produces nitrus oxide, another potential
greenhouse gas, as well as sulphur oxides, which cause acid rain, surprisingly enalyes, however
pollution from global freight is exempt from the Keyoto protocol on green-house gas emissions.
The WTO and Environment:
The WTO has been virtually silent on the environmental issue. Its agenda shows the triumph of
the rights to trade over the right of the environment. Because of its enormous power the WTO
has put trade first and any influence that might reduce the power of global trade a distant second.
Two of the most notable anti-environmental decisions of the GATTAVTO involved measures to
save dolphins and sea-turtles. But nothing much happened in practice since restriction on use of
shrimp netting which kills sea-turtles amounts to unfair trade barrier. A progressive and far-
sighted measure to protect the environment was never taken by the WTO can it was supposed to
hamper fewer multilateral trades.
Human Health:
Trade not only affects the natural environment but human health also. Through the world
artificial breast milk substitutes contribute the high incidence of child mortality. Often fatal
infant diarrohoea is contracted when mothers mix the formula with unsafe water. The costs
largely go unnoticed when the benefits of global trade are considered. But they are real and they
must be given the same weight as the financial merits (or demerits) of over- expanding global
trade.
Two Barriers to Environmental Protection:
Two of the WTO measures go against environmental protection. The first is that governments
are not allowed to discriminate among foreign products or b/w foreign and domestic producers of
a ‘like’ product. The second is that no environmental measure is treated as legitimate unless it is
both ‘necessary’ and least trade restrictive means of achieving the desired environmental
outcome. Very few environmental measures can overcome these problems.
The WTO Limits on the Spread of Environmental Technologies:
Another harmful way in which the WTO works against the environment is through the trade
related intellectual property rights (TRIPS) agreement. The TRIPS agreement is a global
copy-right agreement which introduced strict new rules that enhanced the intellectual property
right of transnational corporation which were concerned about the loss of global sales due to
proliferation of generic copies of their products.
Apart from protecting the market of large drug and pharma companies the TRIPS agreement also
protects the market of companies that produce environment friendly technologies. Consequently
developing countries like India often cannot use new technologies and improve their
environmental performance.
The WTO and Global Warming:
The WTO has also failed in its efforts to stop global warming. For instance, two major car
manufacturing regions of the world—the European Community and the USA—are eager to
reduce greenhouse emission but does not want to lose their share of international market. So no
one is able to reduce greenhouse emission for fear of deviating from free trade.
There is a strange apprehension that initiatives which reduce greenhouse emissions could
undermine a country’s trade competitiveness. This, in turn, poses a serious challenge to
international efforts to stop global warming. There is always the danger of losing a competitive
edge in the global market. This very fact seems to be the greatest single barrier to achieve lower
global greenhouse emission.
In 1992 an attempt to introduce carbon tax failed for the fear of losing trade competitiveness;
likewise the US opposed the ratification of the Kyoto Protocol. It was argued that signing the
protocol would result in hundreds of manufacturing plants being relocated to low income
countries that are not bound by the Kyoto Protocol.
Foreign Investment:
Falling investment is a huge driver of global trade and financial capital is the most mobile of all
factors. In addition, it has an extra temptation to go abroad in search of higher return. Moreover,
the sad truth is that the mobility of global investment has made it very easy for business to
relocate to new countries to take advantage of looser environmental controls. According, to one
estimate made by the United Nations b/w 20 and 50% of all foreign investment that goes into
low-income countries is invested in pollution-intensive industries.
The tragic incidence of gas leakage from Union Carbide’s Bhopal plant is the most infamous
example of this opportunistic type of investment. Like India, Mexico has become a haven for
foreign in-vestors—particularly US investors—who seek slack environmental regulations.
At times just the threat of relocation can be sufficient to force loose environmental control.
Excess control on a falling farm by the hast government can force it to leave the country and
relocate elsewhere. Such runaway factories are likely to aggravate the unemployment problem in
labour surplus countries.
Investor Law Suits:
In some regional trade agreements like NAFTA the right to resort to legal action extends
environmental measure. Under the NAFTA rules, if an investor feels that its rights are
compromised by environmental measures he can take legal action in the matter. Money investors
have done so in the recent past.
The Global Spread of the Environmental Impact of Trade:
Perhaps the most devastating effect of global trade is the way it makes all the world’s natural
resources available for potential plunder. Trade has made all the world’s natural resources
available to all the world’s producers. Global trade has removed all barrier to the exploitation of
the world’s natural resources.

Some of the major impacts of this unbridled ability to exploit all the world’s natural re-sources
have been the following:
(1) The world has lost half of its original forest cover b/w 1960 and 1990.
(2) By 2000, more than 75% of the world’s major marine fish stocks had either been depleted
through once fishing or had been fished to their ecological limit.
(3) Global production of minerals has increased sharply. So mineral resources which are non-
renewable have been reduced correspondingly.
(4) In the past 25 years alone the world has lost 30% of its biodiversity. It is now losing species
at 10,000 times of the natural rate of extinction.
The Environmental Effect of Global Farming:
Globalisation is also increasingly opening up all the world’s farms for global exploitation. More
and More of the world’s family farms are being converted to factory farms. The larger farmers
use farming methods which are much more chemical and water intensive than the methods used
by the smaller farms. Both are gradually destroying the country’s scarce water resources and
increasing the amount of fertilizer run-off into the seas starving marine life of oxygen.
The mushroom growth of factory farms around the world has had the following
environmental effect:
(1) Global consumption of water is doubling every 25 years. So shortage of water is inevitable in
near future.
(2) Farming is exhausting more and more sails around the world.
(3) Farming sails are becoming less and less sensitive to fertilizer use, resulting in ever
increasing qualities of fertilizer being required for the same output.
The Environmental Destruction Fuelled by Falling Raw Material Prices:
The age-old dependence of many LDCs on the export of raw materials is also a source of major
world wise environmental stress. Due to declining pressure of raw materials, LDCs have to sell
more and more raw materials onto the global market.
But they get less and less money as supply exceeds demand. They are constrained to sell off their
natural resources at lower and lower prices because they have no other option in today’s highly
integrated global market. At the end, the environment pays the price.
WTO’s Wrong Policies:
The ongoing dependency on exports of raw materials by many low income countries are
reinforced by the policies of the WTO. The policies of WTO are virtually neutral with respect to
the patterns of trade of LDCs. What is worse, at times these policies work against ending LDCs’
dependency on raw material’s export.
One policy of WTO, that seeks to maintain LDCs dependency on export of raw materials its
tariff escalation. During the round a schedule of tariffs was negotiated for raw materials which
linked tariffs to the amount of value added to a raw material. The more valued addition was
made, the higher the tariff.
This gives hardly any incentives to LDCs to add value to their export of law materials. So LDCs
are left with no other option but to exploit their natural resources. They are virtually forced by
the WTO to do this. That is why many cities have given the WTO a new name wrong trade
organisation just as the GATT was described by its critics as gentleman’s agreement to talk and
talk.
To conclude with Crreg Buckman:
“Basically free trade is getting a free trade courtesy of the world’s environmental. Both the
structure and the sheer volume of world trade mean the world’s environment pays the price every
time. But the global environment is finite, expanding global trade is eating away at the Earth’s
natural capital-and it is a capital we cannot reinvest in. Once it is gone, it is gone forever. Global
trade desperately needs to open its eyes and ears to the impact it is having on our global
ecosystem”.
3.6. TRADE AND LABOUR STANDARDS
Currently, labour standards are not subject to WTO rules and disciplines. But some WTO
member governments in Europe and North America believe that the issue must be taken up by
the WTO in some form if public confidence in the WTO and the global trading system is to be
strengthened. These member governments argue that the rights such as: the freedom to bargain
collectively, freedom of association, elimination of discrimination in the workplace and the
elimination workplace abuse (including forced labour and certain types of child labour), are
matters for consideration in the WTO. Several member governments have suggested that the
issue be brought into the WTO through the formation of a working group to study the issue of
trade and core labour standards. Bringing the matter to the WTO, these member governments
believe, will provide incentives for WTO member governments to improve conditions for
workers around the world.
This proposal is among the most controversial currently before the WTO.
Most developing countries and many developed nations believe the issue of core labour
standards does not belong in the WTO. These member governments see the issue of trade and
labour standards as a guide for protectionism in developed-country markets. Developing-country
officials have said that efforts to bring labour standards into the WTO represent a smokescreen
for undermining the comparative advantage of lower-wage developing countries.
Many officials in developing countries argue that better working conditions and improved labour
rights arise through economic growth. They say that if the issue of core labour standards became
enforceable under WTO rules, any sanctions imposed against countries with lower labour
standards would merely perpetuate poverty and delay improvements in workplace standards.
The issue of trade and labour standards has been with the WTO since its birth. At the Ministerial
Conference of the General Agreement on Tariffs and Trade held in Marrakesh in April 1994 to
sign the treaty that formed the WTO, nearly all ministers expressed a point of view on the issue.
The Chairman of that conference concluded there was no consensus among member
governments at the time, and thus no basis for agreement on the issue.
At the first WTO Ministerial Conference in Singapore in December 1996 the issue was taken up
and addressed in the Ministerial Declaration. At Singapore, Ministers stated:
“We renew our commitment to the observance of internationally recognized core labour
standards. The International Labour Organization (ILO) is the competent body to set and deal
with these standards, and we affirm our support for its work in promoting them. We believe that
economic growth and development fostered by increased trade and further trade liberalization
contribute to the promotion of these standards. We reject the use of labour standards for
protectionist purposes, and agree that the comparative advantage of countries, particularly low-
wage developing countries, must in no way be put into question. In this regard, we note that the
WTO and ILO Secretariats will continue their existing collaboration.”
Since taking office in September 1999, WTO Director-General Mike Moore, has met twice with
ILO Director-General Juan Somavia. Mr Moore has said he looks forward to co-operating with
Mr Somavia and other officials from the ILO. He has also been clear that the WTO will be
guided by Ministers on the issue of trade and core labour standards.
Existing collaboration between the WTO and the ILO includes participation by the WTO in
meetings of ILO bodies, the exchange of documentation and informal cooperation between the
ILO and WTO Secretariats.
Since the Singapore Ministerial Conference, the ILO has taken two significant steps in
addressing the issue of workers’ rights. In 1998, ILO member governments adopted the ILO
Declaration on Fundamental Principles and Rights at Work and its Follow-up. Under this
declaration, ILO member governments endorsed some basic principles which are included in the
core ILO Conventions. (These conventions are the fundamental workplace rights including:
freedom of association and recognition of the right to collective bargaining; elimination of all
forms of forced labour; the effective abolition of child labour and the elimination of
discrimination in hiring and employment practices.)
ILO Member Governments agreed to respect and promote these Core Conventions even if they
have not ratified all of them. As a follow-up, the ILO will issue annual reports in which ILO
officials will obtain information from governments which have not ratified all of the conventions
on any changes that may have taken place in national laws or regulations and which may impact
these fundamental labour rights.
In 1999, ILO member governments agreed to prohibit and eliminate the worst forms of child
labour. Member governments defined the worst forms of child labour as all forms of slavery,
child prostitution and pornography, the use of children to traffic in drugs and work which is
likely to harm the health, safety or morals of children.
ILO member governments said they recognized that child labour is largely a function of poverty
and that the long-term solution to elimination of exploitative and harmful child labour is through
sustained economic growth.
A recent World Bank study estimated that less than 5% of child workers in the developing world
are involved in export related activities.
The „Trade and Labour‟ linkage is a sensitive and controversial issue for many countries. As
with the case of linkage of other non-trade issues with trade (such as trade and environment, or
trade and intellectual property), the trade and labour debate is characterized by two conflicting
strands of thought: one favouring the inclusion of such a linkage in trade negotiations, and the
other discrediting and denouncing any kind of linkage.
This divergence of views was most visible during the WTO Ministerial Conference at Singapore
in 1996, and again at Seattle in 1999, when developing nations such as Brazil, Egypt, India, and
Malaysia vehemently opposed the pressure from the U.S. to include labour standards within the
ambit of the WTO.1 While this resistance has been responsible for lack of any labour standards
being incorporated under the WTO, labour provisions are increasingly being incorporated in
bilateral and regional preferential trade agreements referred to in this article as “Preferential
Trading Agreements” or PTAs) entered into by the U.S., the EU, New Zealand, and more
recently, by developing countries such as Chile as well.
A recent study by the International Labour Organization (ILO) maps some of the recent trends in
the nature of labour provisions in PTAs and notes that the use of such provisions has especially
increased since the global financial crisis of 2008.2
The scope and approach adopted by PTAs varies widely, such as:
1. Provisions that commit parties to adhere to certain international labour standards, referring to
the „Core Labour Standards‟ defined in the ILO 1998 Declaration;
2. Provisions that commit parties to ILO Conventions generally;
3. Provisions that refer to “internationally-recognized workers rights”; and
4. A general commitment by parties to enforce labour standards under their own national labour
law.
3.7. THEORY OF CUSTOM UNION
Before J. Viner developed the theory of customs union, there was a general belief that customs
union raises the level of welfare as customs union is a movement towards freer trade at least
within a specific area. Viner pointed out that the conclusion concerning increase in welfare due
to customs union is not necessarily true.
He analysed the production effects of customs union through the concepts of trade creation and
trade diversion. The works of the writers like Meade, Lipsey, Lancaster and many others
analysed the consumption effects. H.G. Johnson followed a partial equilibrium approach to
investigate fully the effects of a customs union by incorporating both the production and
consumption effects.
Partial Equilibrium Analysis of Customs Union:
A custom union is an organisation that includes two or more countries. They abolish tariff and
other trade restrictions among themselves and adopt a common external tariff against the non-
member countries.
The static effects of a customs union in a partial equilibrium system, on the lines suggested
by Viner, Meade, Lipsey and Johnson, can be studied on the basis of the assumptions given
below:
(i) The customs union includes two countries—the home country A and the partner country B.
(ii) The rest of the world is denoted by a third country, say country C.
(iii) The customs union imposes a common external tariff.
(iv) There is an absence of any other type of trade restriction.
(v) The customs union imposes only a specific tariff.
(vi) The three countries produce only one commodity says, X.
(vii) The home country A was the highest cost country and the country C was the least cost
country before the formation of the customs union.
(viii) The supply curves are perfectly elastic in countries A and C.
(ix) The production is governed by constant returns to scale.
(x) There is perfect competition in both product and factor markets.
(xi) The supply of productive inputs is fixed.
(xii) There is a state of full employment of resources.
(xiii) The techniques of production are given and constant.
(xiv) The transport costs are absent.
(xv) The home country is originally having balance of trade equilibrium, i.e., exports equal
imports.
The effects of customs union on production, consumption and trade, given the above
assumptions, can be explained in terms of trade creation and trade diversion due to customs
union.
(a) Trade Creation:
The formation of customs union involves the abolition of tariff among the member countries and
imposition of common tariff against the rest of the world. It is supposed that the home country A
is the least efficient country and its unit cost of producing a watch is Rs. 1000.
In the partner country B, which is more efficient, the unit cost of production of that watch is Rs.
800. The rest-of-the world is represented by non-member country C, which is the most efficient
and the average cost of producing the same watch is Rs. 700 in that country.
If, before the formation of custom union, the home country A imposes 100 percent tariff on all
imports, the unit costs in B and C become Rs. 1600 and Rs. 1400 respectively. In these
circumstances, it is desirable for the home country A to produce the commodity domestically. If
the customs union is formed and duty is removed on imports from B but it remains in the case of
country C, the partner country B becomes the least cost country. Now the home country will
prefer to import watches from B rather than produce it domestically. So the formation of customs
union has resulted in the creation of trade.

(b) Trade Diversion:

It is possible that before the formation of the customs union, a given commodity (watches) was
being imported from the most efficient and the least cost country C. After the formation of the
customs union, as duty is removed from import from the partner country B, while it remains
enforced on imports from C, the former becomes the least cost country.
In such a situation, the home country A will start importing watches from the partner country B
rather than non-member country C. Thus there is diversion of trade from outside country C to the
partner country B after the formation of the customs union. It may be explained through the table
below

.
Table above shows that the unit costs of watch in the home country (A), partner country (B) and
non-member country (C) before the formation of the customs union were Rs. 1000, Rs. 800 and
Rs. 600 respectively. Thus country C was the least cost or the most efficient country and the
home country A was the highest cost country.
As the home country imposes 50 percent duty on all imports, the unit costs in A, B and C
become Rs. 1000, Rs. 1200 and Rs. 900 respectively. Since C is the least cost country, watches
will be imported by A from this country.
After the formation of the customs union, the import duty is abolished on imports from B, while
it remains in case of non-member country C. The unit costs, in this situation, are Rs. 1000, Rs.
800 and Rs. 900 in case of A, B and C respectively. As a consequence, country A will prefer to
import watches from country B (partner country) rather than the outside country C. Thus the
formation of customs union results in the diversion of trade from an outside country to the
partner country. This is called as the trade diversion.
The partial equilibrium effects of the formation of the customs union can be analysed with the
help of Fig. below.
In Fig. above., quantity of the commodity (watches) is measured along the horizontal scale and
price along the vertical scale. DA and SA are the demand and supply curves respectively of the
home country A. SB and SC are the perfectly elastic supply curves of countries B and C
respectively. The selling price of country A is OP1 whereas the selling prices of countries B and
C are respectively OP3 and OP2. Thus country C is the most efficient and the home country A is
the least efficient.
Before the formation of the customs union, country A imposes P2P4 per unit tariff on all imports.
Now the tariff-ridden price for country C is OP2 + P2P4 = OP4. It is still lower than A’s selling
price OP1. Country B is out of picture because its selling price inclusive of tariff is even higher
than A’s selling price. Country A will enter into trade with country C.
At the tariff-ridden price OP4, the domestic production by country A is OQ1 and the demand is
OQ2 so that the quantity imported from country C is Q1Q2. The consumer’s surplus in this trade
equilibrium is D0FP4 and producer’s surplus is S0EP4. The revenue receipts of the government
in country A are EFLK. The measure of welfare before the formation of the customs union is
D0FP4 + S0EP4 + EFLK = D0FLKE S0.
If customs union is formed and the tariffs are removed in case of partner country B, while these
continue to exist in case of the non-member country C. As the selling price OP3 of country B is
lower than that of country C, the home country will import watches from the partner country B
and country C gets eliminated from trade.
The main effects after the formation of customs union are as follows:
a. Price Effect:
As compared to the tariff-ridden price OP4, there is a fall in the selling price to OP3 after the
customs union is formed.
b. Production Effect:
Before the formation of the custom union, the domestic production in country A was OQ1. After
the customs union is formed, the domestic production falls from OQ1 to OQ3. This fall in output
is met through imports. The overall import is Q3Q4 which is more than the earlier imports Q1Q2.
The increase in imports Q1Q3 that offsets the fall in domestic production is termed as Trade
Creation Effect I.
c. Consumption Effect:
Before the formation of customs union, the quantity demanded was OQ 2 and afterwards it is
OQ4. Thus the demand for watches rises by Q2Q4. This additional demand is met through
imports from the partner country B. Thus the increase in consumption Q2Q4 is the consumption
effect. It is referred as Trade Creation Effect II. Jacob Viner had over-looked it but the writers
like Meade, Gehrels, Lipsey and Johnson have recognised it.
d. Revenue Effect:
Before the formation of the customs union, the government in country A was obtaining revenues
from tariff to the tune of EFLK. After the formation of customs union, since imports are being
made from the partner country B, the government does not receive any revenues. Thus there is
loss in government revenues to the extent of EFLK.
Given the trade creation effects I and II the total trade creation effect is (Q1Q3 + Q2O4).
e. Welfare Effect:
The welfare effect due to trade creation can be assessed as below:
Gain in Consumer’s Surplus = P4FHP3
Loss in Producer’s Surplus = P4EGP3
Loss in Government Revenues = EFLK
Welfare Effect = P4FHP3 – P4EGP3 – EFLK = ΔEKG + ΔFLH
Trade Diversion and Reduction in Welfare:
While the trade creation results in a gain in welfare, the diversion of trade from a non-member
country (C) to the member country (B) after the formation of customs union, involves some loss
in welfare. The reason for it is that the trade gets diverted from a more efficient or low cost
country C to the less efficient or high cost country B.
Before the formation of customs union, the home country A was importing Q1Q2 quantity of the
commodity from the non-member country C. After the formation of customs union, the quantity
imported is Q3Q4 out of which Q3Q1 and Q2Q4 can be identified as trade creation effect and the
remaining quantity imported Q1Q2 is the trade diversion effect.
Before the formation of the customs union, the payment for importing Q1Q2 quantity was
Q1EFQ2. Out of it the revenue receipts to the government of the home country amounted to (P2P4
× Q1Q2 = EMNF). So the actual payment to country C for the import of Q1Q2 quantity of
watches was Q1MNQ2.
After the formation of the customs union, the same quantity Q1Q2 is being imported from the
partner country B on account of trade diversion. Since no tariff is applicable to B, the total
payment to it due to import amounts to OP3 × Q1Q2 = KQ1 × Q1Q2 = Q1KLQ2.
Thus there is a larger external payment for importing the same quantity after the formation of the
customs union to the extent of Q1KLQ2 – Q1MNQ2 = KMNL which is shown through shaded
area in Fig Above.
This represents a loss or reduction in welfare. From this, it follows that trade diversion causes a
reduction in welfare. The simple reason for the decline in welfare is that the imports are made
from less efficient (high cost) partner country B rather than more efficient (low cost) non-
member country C.
f. Net Welfare Effect of Custom Union:
The trade creation results in an increase in welfare. It is depicted by areas ΔEKG and ΔFLH in
Fig.. The trade diversion, on the contrary, causes a reduction in welfare. In Fig. it has been
shown by the area KMNL. Therefore the formation of customs union may either cause a net
increase or reduction in welfare.
(i) If KMNL = (ΔEKG + ΔFLH), there is neither an increase nor a decrease in net welfare.
(ii) If KMNL < (ΔEKG + ΔFLH), the formation of customs union results in a net increase in
welfare of the home country A.
(iii) If KMNL > (ΔEKG + ΔFLH), the formation of customs union leads to a net loss in welfare
in country A.
3.8. STATIC AND DYNAMIC EFFECTS OF A CUSTOMS UNION AND FREE TRADE
AREAS
Static Effects of Custom Union
There are trade creation effects and trade diversion effects. The trade creation effect refers to the
benefits generated by products from domestic production with higher production costs to the
production of customs union countries with lower costs. The trade diversion effect refers to the
loss incurred when a product is imported from a non-member country with lower production
costs to a member country with a higher cost. This is the price of joining the customs union.
When the trade creation effect is greater than the transfer effect, the combined effect of joining
the Customs Union on the member countries is net profit, which means an increase in the
economic welfare level of the member countries; otherwise, it is a net loss and a decline in the
economic welfare level.
The trade creation effect is usually regarded as a positive effect. This is because the domestic
production cost of country A is higher than the production cost of country A 's imports from
country B. The Customs Union made Country A give up the domestic production of some
commodities and change it to Country B to produce these commodities. From a worldwide
perspective, this kind of production conversion improves the efficiency of resource allocation
Dynamic Effects of Customs Union:
The static effects of customs union are-
(i) trade- creation and
(ii) trade-diversion.
The static effects are basically concerned with reallocation of production and consumption. In
fact the formation of the customs union initiates a process of structural and technical
readjustments, on the one hand, amongst the member countries and, on the other, among the non-
member countries.
Such long-lasting dynamic effects of customs union have been greatly emphasised by the writers
like T. Scitovsky, B. Belassa and W.M. Corden.
The dynamic effects of customs union are as follows:
1. Increased Competition:
The most significant dynamic effect of customs union is the increase in intensity of competition
within the union. Earlier in the sheltered markets, the monopolistic and oligopolistic industries
had become sluggish and complacent. After the formation of customs union, as they are exposed
to competition from rival firms within the union, they have to operate in the most efficient way
or face the risk of elimination.
All the firms, earlier operating below their optimum productive capacity, make efforts to expand
production in order to cater to the demand from an expanded market and to minimise their costs.
Competition also stimulates the managerial efficiency and induces the industries to utilize new
technology.
The customs union must take care that collusion and market-sharing arrangements, which had
earlier restricted competition at the national level, should not restrict competition at the union
level. In this direction, the member countries should enforce anti-trust legislation throughout the
customs union.
2. Economies of Scale:
When a customs union is formed, expansion in the size of market, increased competition,
increased specialisation and consequent enlargement of plant size lead to the emergence of
internal and external economies of scale. This is evident from the experience of the countries of
European Community (EC). The formation of EC resulted in economies of scale due to reduction
in the range of differentiated products, increase in production run, pooling of skilled labour,
capital resources, research and management.
3. Stimulus to Investment:
The expansion of market and more intensified competition stimulates investment activity. The
need for introducing new techniques and accelerated depreciation of the existing plants and
equipment step up greatly the rate of investment. In addition, there is also strong stimulus to
foreign investment. Many non-member countries set up their plants in the territory of union
members so that their products can evade the tariff barriers.
Such industrial units are called as tariff factories. The massive United States investments in
Europe after 1955 were probably on account of the American desire of not to be excluded from
the rapidly expanding market of EC.
4. Movement of Productive Factors:
After the formation of customs union, or more particularly, the common market, there is free
movement of labour, capital and enterprise within the entire region of the common market. This
ensures the optimal utilization of resources, increase in factor productivity and consequent rise in
the growth rate of the economies of all the countries in the union.
5. Technological Advance:
As a customs union is formed, expansion in the size of market, greater competition, need for
increasing the scale of production and achieving higher factor productivity, make the firms and
industries develop very strong urge to imitate, to innovate and to make commercial application
of technical, scientific and managerial innovations.
There is strong stimulus to research for making improvements in the production techniques,
processes of production and quality of products. The intense technological developments tend to
push up the rate of economic growth.
6. Improvements in the Terms of Trade:
The formation of the customs union results in raising of external tariffs against the outside world
and consequent reduction in imports from abroad. This tends to raise the bargaining power of the
union members against the rest-of-the-world. The improvement in the terms of trade brings about
also an improvement in the balance of payments position of the member countries.
7. Reduction of Risk and Uncertainty:
The foreign transactions often involve high degree of risk. The complexity of trade regulations,
unilateral changes by countries in the tariff and non-tariff trade restraints and foreign exchange
regulations create much uncertainty. The economic integration reduces to a significant extent,
risk and uncertainty particularly in respect of the inter-member transactions.
It is on account of these dynamic benefits that the West European countries and the countries of
certain other regions deemed it appropriate to organise themselves into some form of economic
integration. The recent empirical studies seem to indicate that the dynamic gains of customs
unions are five to six times larger than the static gains.
3.9. RATIONALE AND ECONOMIC PROGRESS OF:
EUROPEAN UNION
European Union (EU), international organization comprising 27 European countries and
governing common economic, social, and security policies. Originally confined to western
Europe, the EU undertook a robust expansion into central and eastern Europe in the early 21st
century. The EU’s members are Austria, Belgium, Bulgaria, Croatia, Cyprus, the Czech
Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia,
Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia,
Spain, and Sweden. The United Kingdom, which had been a founding member of the EU, left the
organization in 2020. The EU was created by the Maastricht Treaty, which entered into force on
November 1, 1993. The treaty was designed to enhance European political and economic
integration by creating a single currency (the euro), a unified foreign and security policy, and
common citizenship rights and by advancing cooperation in the areas of immigration, asylum,
and judicial affairs. The EU was awarded the Nobel Prize for Peace in 2012, in recognition of the
organization’s efforts to promote peace and democracy in Europe.
Origins
The EU represents one in a series of efforts to integrate Europe since World War II. At the end of
the war, several western European countries sought closer economic, social, and political ties to
achieve economic growth and military security and to promote a lasting reconciliation between
France and Germany. To this end, in 1951 the leaders of six countries—Belgium, France, Italy,
Luxembourg, the Netherlands, and West Germany—signed the Treaty of Paris, thereby, when it
took effect in 1952, founding the European Coal and Steel Community (ECSC). (The United
Kingdom had been invited to join the ECSC and in 1955 sent a representative to observe
discussions about its ongoing development, but the Labour government of Clement Attlee
declined membership, owing perhaps to a variety of factors, including the illness of key
ministers, a desire to maintain economic independence, and a failure to grasp the community’s
impending significance. The ECSC created a free-trade area for several key economic and
military resources: coal, coke, steel, scrap, and iron ore. To manage the ECSC, the treaty
established several supranational institutions: a High Authority to administrate, a Council of
Ministers to legislate, a Common Assembly to formulate policy, and a Court of Justice to
interpret the treaty and to resolve related disputes. A series of further international treaties and
treaty revisions based largely on this model led eventually to the creation of the EU.
Creation of the European Economic Community
On March 25, 1957, the six ECSC members signed the two Treaties of Rome that established the
European Atomic Energy Community (Euratom)—which was designed to facilitate cooperation
in atomic energy development, research, and utilization—and the European Economic
Community (EEC). The EEC created a common market that featured the elimination of most
barriers to the movement of goods, services, capital, and labour, the prohibition of most public
policies or private agreements that inhibit market competition, a common agricultural policy
(CAP), and a common external trade policy.
The treaty establishing the EEC required members to eliminate or revise important national laws
and regulations. In particular, it fundamentally reformed tariff and trade policy by abolishing all
internal tariffs by July 1968. It also required that governments eliminate national regulations
favouring domestic industries and cooperate in areas in which they traditionally had acted
independently, such as international trade (i.e., trade with countries outside the EEC). The treaty
called for common rules on anticompetitive and monopolistic behaviour and for common inland
transportation and regulatory standards. Recognizing social policy as a fundamental component
of economic integration, the treaty also created the European Social Fund, which was designed to
enhance job opportunities by facilitating workers’ geographic and occupational mobility.
Map showing the composition of the European Economic Community (EEC) from 1957, when it
was formed by the members of the European Coal and Steel Community (ECSC), to 1993, when
it was renamed the European Community (EC) and was subsumed under the European Union
(EU).
Significantly, the treaty’s common market reforms did not extend to agriculture. The CAP,
which was implemented in 1962 and which became the costliest and most controversial element
of the EEC and later the EU, relied on state intervention to protect the living standards of
farmers, to promote agricultural self-sufficiency, and to ensure a reliable supply of products at
reasonable prices.
Like the ECSC, the EEC established four major governing institutions: a commission, a
ministerial council, an assembly, and a court. To advise the Commission and the Council of
Ministers on a broad range of social and economic policies, the treaty created an Economic and
Social Committee. In 1965 members of the EEC signed the Brussels Treaty, which merged the
commissions of the EEC and Euratom and the High Authority of the ECSC into a single
commission. It also combined the councils of the three organizations into a common Council of
Ministers. The EEC, Euratom, and the ECSC—collectively referred to as the European
Communities—later became the principal institutions of the EU.
The Commission (officially known as the European Commission) consists of a permanent civil
service directed by commissioners. It has had three primary functions: to formulate community
policies, to monitor compliance with community decisions, and to oversee the execution of
community law. Initially, commissioners were appointed by members to renewable four-year
terms, which were later extended to five years. The Commission is headed by a president, who is
selected by the heads of state or heads of government of the organization’s members. In
consultation with member governments, the president appoints the heads of the Directorate-
Generals, which manage specific areas such as agriculture, competition, the environment, and
regional policy. The Commission has shared its agenda-setting role with the European Council
(not to be confused with the Council of Europe, an organization that is not an EU body), which
consists of the leaders of all member countries. Established in 1974, the European Council meets
at least twice a year to define the long-term agenda for European political and economic
integration. The European Council is led by a president, an office that originally rotated among
the heads of state or heads of government of member countries every six months. Upon the
adoption of the Lisbon Treaty in 2009, the presidency was made permanent, with the
officeholder being selected by European Council members. The president of the European
Council serves a term of two and a half years—renewable once—and functions as the “face” of
the EU in policy matters. The first “president of the EU,” as the office came to be known, was
former Belgian prime minister Herman Van Rompuy.
The main decision-making institution of the EEC and the European Community (as the EEC was
renamed in 1993) and the EU has been the Council of the European Union (originally the
Council of Ministers), which consists of ministerial representatives. The composition of the
council changes frequently, as governments send different representatives depending on the
policy area under discussion. All community legislation requires the approval of the council. The
president of the council, whose office rotates among council members every six months,
manages the legislative agenda. Council meetings are chaired by a minister from the country that
currently holds the presidency. The exception to this rule is the Foreign Affairs Council, which,
since the ratification of the Lisbon Treaty, is under the permanent supervision of the EU high
representative for foreign affairs and security policy.
The Common Assembly, renamed the European Parliament in 1962, originally consisted of
delegates from national parliaments. Beginning in 1979, members were elected directly to five-
year terms. The size of members’ delegations varies depending on population. The Parliament is
organized into transnational party groups based on political ideology—e.g., the Party of
European Socialists, the European People’s Party, the European Federation of Green Parties, and
the European Liberal, Democrat and Reform Party. Until 1987 the legislature served only as a
consultative body, though in 1970 it was given joint decision-making power (with the Council of
Ministers) over community expenditures.
The European Court of Justice (ECJ) interprets community law, settles conflicts between the
organization’s institutions, and determines whether members have fulfilled their treaty
obligations. Each member selects one judge, who serves a renewable six-year term; to increase
efficiency, after the accession of 10 additional countries in 2004 the ECJ was allowed to sit in a
“grand chamber” of only 13 judges. Eight impartial advocates-general assist the ECJ by
presenting opinions on cases before the court. In 1989 an additional court, the Court of First
Instance, was established to assist with the community’s increasing caseload. The ECJ has
established two important legal doctrines. First, European law has “direct effect,” which means
that treaty provisions and legislation are directly binding on individual citizens, regardless of
whether their governments have modified national laws accordingly. Second, community law
has “supremacy” over national law in cases where the two conflict. The promulgation of the
Lisbon Treaty signaled the acceptance of these legal doctrines by national courts, and the ECJ
has acquired a supranational legal authority.
Throughout the 1970s and ’80s the EEC gradually expanded both its membership and its scope.
In 1973 the United Kingdom, Denmark, and Ireland were admitted, followed by Greece in 1981
and Portugal and Spain in 1986. (The United Kingdom had applied for membership in the EEC
in 1963 and in 1966, but its application was vetoed by French Pres. Charles de Gaulle.) The
community’s common external trade policy generated pressure for common foreign and
development policies, and in the early 1970s the European Political Cooperation (EPC; renamed
the Common Foreign and Security Policy by the Maastricht Treaty), consisting of regular
meetings of the foreign ministers of each country, was established to coordinate foreign policy.
In 1975 the European Regional Development Fund was created to address regional economic
disparities and to provide additional resources to Europe’s most deprived areas. In the same year,
members endorsed the Lomé Convention, a development-assistance package and preferential-
trade agreement with numerous African, Caribbean, and Pacific countries. Members also made
several attempts to manage their exchange rates collectively, resulting in the establishment of the
European Monetary System in 1979.
Single European Act
The Single European Act (SEA), which entered into force on July 1, 1987, significantly
expanded the EEC’s scope. It gave the meetings of the EPC a legal basis, and it called for more
intensive coordination of foreign policy among members, though foreign policy decisions were
made outside community institutions. The agreement brought the European Regional
Development Fund formally into the community’s treaties as part of a new section on economic
and social cohesion that aimed to encourage the development of economically depressed areas.
As a result of the act, there was a substantial increase in funding for social and regional
programs. The SEA also required the community’s economic policies to incorporate provisions
for the protection of the environment, and it provided for a common research and technological-
development policy, which was aimed primarily at funding transnational research efforts.
More generally, the SEA set out a timetable for the completion of a common market. A variety
of legal, technical, fiscal, and physical barriers continued to limit the free movement of goods,
labour, capital, and services. For example, differences in national health and safety standards for
consumer goods were a potential impediment to trade. To facilitate the completion of the
common market by 1992, the community’s legislative process was modified. Originally, the
Commission proposed legislation, the Parliament was consulted, and the Council of Ministers
made a final decision. The council’s decisions generally needed unanimity, a requirement that
gave each member a veto over all legislation. The SEA introduced qualified majority voting for
all legislation related to the completion of the common market. Under this system, each member
was given multiple votes, the number of which depended on national population, and approval of
legislation required roughly two-thirds of the votes of all members. The new procedure also
increased the role of the European Parliament. Specifically, legislative proposals that were
rejected by the Parliament could be adopted by the Council of Ministers only by a unanimous
vote.
The Maastricht Treaty
The Maastricht Treaty (formally known as the Treaty on European Union), which was signed on
February 7, 1992, created the European Union. The treaty met with substantial resistance in
some countries. In Denmark, for example, voters who were worried about infringements upon
their country’s sovereignty defeated a referendum on the original treaty in June 1992, though a
revised treaty was approved the following May. Voters in France narrowly approved the treaty in
September, and in July 1993 British Prime Minister John Major was forced to call a vote of
confidence in order to secure its passage. An amended version of the treaty officially took effect
on November 1, 1993.
The treaty consisted of three main pillars: the European Communities, a common foreign and
security policy, and enhanced cooperation in home (domestic) affairs and justice. The treaty
changed the name of the European Economic Community to the European Community (EC),
which became the primary component of the new European Union. The agreement gave the EC
broader authority, including formal control of community policies on development, education,
public health, and consumer protection and an increased role in environmental protection, social
and economic cohesion, and technological research. It also established EU citizenship, which
entailed the right of EU citizens to vote and to run for office in local and European Parliament
elections in their country of residence, regardless of national citizenship.
The Maastricht Treaty specified an agenda for incorporating monetary policy into the EC and
formalized planning that had begun in the late 1980s to replace national currencies with a
common currency managed by common monetary institutions. The treaty defined a set of
“convergence criteria” that specified the conditions under which a member would qualify for
participation in the common currency. Countries were required to have annual budget deficits not
exceeding 3 percent of gross domestic product (GDP), public debt under 60 percent of GDP,
inflation rates within 1.5 percent of the three lowest inflation rates in the EU, and exchange-rate
stability. The members that qualified were to decide whether to proceed to the final stage—the
adoption of a single currency. The decision required the establishment of permanent exchange
rates and, after a transition period, the replacement of national currencies with the common
currency, called the euro. Although several countries failed to meet the convergence criteria
(e.g., in Italy and Belgium public debt exceeded 120 percent of GDP), the Commission qualified
nearly all members for monetary union, and on January 1, 1999, 11 countries—Austria, Belgium,
Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain—
adopted the currency and relinquished control over their exchange rates. Greece failed to qualify,
and Denmark, Sweden, and the United Kingdom chose not to apply for membership. Greece was
admitted to the euro beginning in 2001. Initially used only by financial markets and businesses,
the euro was introduced for use by the general public on January 1, 2002.
The Maastricht Treaty significantly modified the EEC’s institutions and decision-making
processes. The Commission was reformed to increase its accountability to the Parliament.
Beginning in 1995, the term of office for commissioners, who now had to be approved by the
Parliament, was lengthened to five years to correspond to the terms served by members of the
Parliament. The ECJ was granted the authority to impose fines on members for noncompliance.
Several new institutions were created, including the European Central Bank, the European
System of Central Banks, and the European Monetary Institute. The treaty also created a regional
committee, which served as an advisory body for commissioners and the Council of Ministers on
issues relevant to subnational, regional, or local constituencies.
One of the most radical changes was the reform of the legislative process. The range of policies
subject to qualified majority voting in the Council of Ministers was broadened. The treaty also
endowed the Parliament with a limited right of rejection over legislation in most of the areas
subject to qualified majority voting, and in a few areas, including citizenship, it was given veto
power. The treaty formally incorporated the Court of Auditors, which was created in the 1970s to
monitor revenue and expenditures, into the EC.
As part of the treaty’s second pillar, members undertook to define and implement common
foreign and security policies. Members agreed that, where possible, they would adopt common
defense policies, which would be implemented through the Western European Union, a security
organization that includes many EU members. Joint actions—which were not subject to
monitoring or enforcement by the Commission or the ECJ—required unanimity.
The EU’s third pillar included several areas of common concern related to the free movement of
people within the EU’s borders. The elimination of border controls conflicted with some national
immigration, asylum, and residency policies and made it difficult to combat crime and to apply
national civil codes uniformly, thus creating the need for new Europe-wide policies. For
example, national asylum policies that treated third-country nationals differently could not, in
practice, endure once people were allowed to move freely across national borders.
Enlargement and post-Maastricht reforms
On January 1, 1995, Sweden, Austria, and Finland joined the EU, leaving Iceland, Norway, and
Switzerland as the only major western European countries outside the organization. Norway’s
government twice (1972 and 1994) attempted to join, but its voters rejected membership on each
occasion. Switzerland tabled its application in the early 1990s. Norway, Iceland, and the
members of the EU (along with Liechtenstein) are members of a free trade area called the
European Economic Area, which allows freedom of movement for goods, services, capital, and
people.
Two subsequent treaties revised the policies and institutions of the EU. The first, the Treaty of
Amsterdam, was signed in 1997 and entered into force on May 1, 1999. Building on the social
protocol of the Maastricht Treaty, it identified as EU objectives the promotion of employment,
improved living and working conditions, and proper social protection; added sex-discrimination
protections and transferred asylum, immigration, and civil judicial policy to the community’s
jurisdiction; granted the Council of Ministers the power to penalize members for serious
violations of fundamental human rights; and gave the Parliament veto power over a broad range
of EC policies as well as the power to reject the European Council’s nominee for president of the
Commission.
A second treaty, the Treaty of Nice, was signed in 2001 and entered into force on February 1,
2003. Negotiated in preparation for the admission of new members from eastern Europe, it
contained major reforms. The maximum number of seats on the Commission was set at 27, the
number of commissioners appointed by members was made the same at one each, and the
president of the Commission was given greater independence from national governments.
Qualified majority voting in the Council of Ministers was extended to several new areas.
Approval of legislation by qualified voting required the support of members representing at least
62 percent of the EU population and either the support of a majority of members or a
supermajority of votes cast. Although national vetoes remained in areas such as taxation and
social policy, countries choosing to pursue further integration in limited areas were not precluded
from doing so.
After the end of Cold War, many of the former communist countries of eastern and central
Europe applied for EU membership. However, their relative lack of economic development
threatened to hinder their full integration into EU institutions. To address this problem, the EU
considered a stratified system under which subsets of countries would participate in some
components of economic integration (e.g., a free trade area) but not in others (e.g., the single
currency). Turkey, at the periphery of Europe, also applied for membership, though its
application was controversial because it was a predominantly Islamic country, because it was
widely accused of human rights violations, and because it had historically tense relations with
Greece (especially over Cyprus). Despite opposition from those who feared that expansion of the
EU would stifle consensus and inhibit the development of Europe-wide foreign and security
policies, the EU in 2004 admitted 10 countries (Cyprus, the Czech Republic, Estonia, Hungary,
Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia), all but two of which (Cyprus and
Malta) were former communist states; Bulgaria and Romania joined in 2007. Negotiations on
Turkey’s membership application began in 2005 but faced numerous difficulties.
Building on the limited economic and political goals of the ECSC, the countries of western
Europe have achieved an unprecedented level of integration and cooperation. The degree of legal
integration, supranational political authority, and economic integration in the EU greatly
surpasses that of other international organizations. Indeed, although the EU has not replaced the
nation-state, its institutions have increasingly resembled a parliamentary democratic political
system at the supranational level.
In 2002 the Convention on the Future of Europe, chaired by former French president Valéry
Giscard d’Estaing, was established to draft a constitution for the enlarged EU. Among the most
difficult problems confronting the framers of the document was how to distribute power within
the EU between large and small members and how to adapt the organization’s institutions to
accommodate a membership that would be more than four times larger than that of the original
EEC. The framers also needed to balance the ideal of deeper integration against the goal of
protecting members’ national traditions. The drafting process evoked considerable controversy,
particularly over the question of whether the constitution should mention God and the Christian
heritage of much of European society (the final version did not). The proposed constitution was
signed in 2004 but required ratification by all EU members to take effect; voters in France and
the Netherlands rejected it in 2005, thereby scuttling the constitution at least in the short term. It
would have created a full-time president, a European foreign minister, a public prosecutor, and a
charter of fundamental rights. Under the constitution the powers of the European Parliament
would have been greatly expanded and the EU given a “legal personality” that entailed the sole
right to negotiate most treaties on its members’ behalf.
Under the leadership of Germany, work began in early 2007 on a reform treaty intended to
replace the failed constitution. The resulting Lisbon Treaty, signed in December 2007, required
approval by all 27 EU member countries in order to take effect. The treaty, which retained
portions of the draft constitution, would establish an EU presidency, consolidate foreign policy
representation for the EU, and devolve additional powers to the European Commission, the
European Court of Justice, and the European Parliament. Unlike the draft constitution, the
Lisbon Treaty would amend rather than replace existing treaties. The treaty failed, at least in the
short term, in June 2008 after it was rejected by voters in a national referendum in Ireland.
However, in a second referendum, in October 2009, Irish voters—apparently concerned that
another “no” vote would imperil Ireland’s ailing economy—overwhelmingly approved the
treaty. A week after the Irish vote, Poland completed its ratification of the treaty as well. At that
time the treaty remained to be ratified by only one country, the Czech Republic. Although the
Czech Parliament already had approved the treaty, Czech Pres. Václav Klaus expressed concern
that it would threaten Czech sovereignty and refused to sign it. In early November, after the
Czech Constitutional Court ruled that the treaty did not imperil the Czech constitution, Klaus
reluctantly endorsed the document, completing the country’s ratification process. Having been
approved by all 27 member countries, the treaty entered into force on December 1, 2009.
The Euro-Zone Debt Crisis
The sovereign debt crisis that rocked the euro zone beginning in 2009 was the biggest challenge
yet faced by the members of the EU and, in particular, its administrative structures. The
economic downturn began in Greece and soon spread to include Portugal, Ireland, Italy, and
Spain (collectively, the group came to be known informally as “PIIGS”), threatening the survival
of the single currency and, some believed, the EU itself. As confidence in the afflicted
economies continued to erode, rating agencies downgraded the countries’ creditworthiness.
Borrowing costs soared as government bond yields rose, and the PIIGS countries found it
increasingly difficult to obtain financing. A series of stopgap measures were undertaken by the
EU and the International Monetary Fund in an attempt to halt the spread of the crisis, but it soon
became apparent that a larger, more-organized response would be required.
Representing the two largest economies in the euro zone, German Chancellor Angela Merkel and
French Pres. Nicolas Sarkozy spearheaded the effort to stabilize the euro—which had plunged to
a four-year low against the U.S. dollar—and preserve the solvency of at-risk euro-zone members.
A bailout package was approved for Greece in May 2010, and, over the next two years, similar
rescue funds were assembled for Ireland, Portugal, Spain, and Cyprus. The economic crisis, and
the austerity measures associated with it, took a staggering political toll on ruling parties across
the continent. Between March 2011 and May 2012, more than half of the euro zone’s 17
members saw their governments collapse or change hands.
The debt crisis had revealed dangerous shortcomings within the regulatory measures that
governed the euro zone’s shared economy, most notably the lack of any enforcement mechanism
for the fiscal rules that were outlined in the Maastricht Treaty. EU leaders attempted to correct
this with a new fiscal pact, signed on March 2, 2012. The treaty bound signatories to limit
government deficits to 3 percent of GDP or face automatic penalties. EU leaders also created the
European Stability Mechanism, a permanent bailout fund that officially replaced the EU’s
temporary rescue measures in October 2012. The European Commission also proposed the
integration of the euro zone’s 6,000 financial institutions into a single banking union, with
oversight provided by the European Central Bank. The system would allow for the centralized
supervision of banks’ capital reserves, as well as the restructuring or direct recapitalization of
imperiled banks without regard to national boundaries. As markets calmed and the imminent
danger to the euro zone began to diminish, EU leaders focused on returning the region to a path
of economic growth. The bailout of the Cypriot banking sector in March 2013 was dealt with
almost as a matter of course, while lingering issues, such as endemic youth unemployment,
remained a subject of concern. The EU welcomed its 28th member on July 1, 2013, when
Croatia completed the accession process.
The crisis in Ukraine and the rise of Euroskepticism
In early 2014 the EU faced what was perhaps its greatest foreign policy crisis since the collapse
of Yugoslavia. In November 2013 the former Soviet republics of Georgia and Moldova signed
an association agreement with the EU, pledging closer political and economic ties. Ukraine,
which had been scheduled to sign the agreement, backed out at the last minute under pressure
from Russia. The reversal by Ukrainian Pres. Viktor Yanukovych triggered a wave of popular
protests that turned violent in February 2014. A bloody government crackdown left scores dead
and hundreds wounded, and, with his political base disintegrating, Yanukovych fled to Russia.
As an interim government assumed power in the Ukrainian capital of Kiev, unidentified troops
fielding Russian equipment took control of key sites in Crimea, a Ukrainian autonomous republic
that had a predominantly Russian population. Armed gunmen seized the regional parliament
building, and a pro-Russian prime minister was installed. As the Russian troop buildup
continued, the self-declared Crimean government announced its independence from Ukraine. A
referendum was hastily scheduled, and 97 percent of Crimean voters stated their preference to
join the Russian Federation. EU leaders called for dialogue and enacted economic sanctions
against a number of high-ranking Kremlin officials, and Russian Pres. Vladimir Putin completed
the formal annexation of Crimea on March 21, 2014. That same day Ukrainian interim Prime
Minister Arseniy Yatsenyuk signed a portion of the EU association agreement that had originally
sparked the crisis.
Attention was soon focused closer to home, however, as Brussels struggled with the emergence
of Euroskepticism as a popular movement. Elections for the European Parliament in May 2014
saw unprecedented wins by the U.K. Independence Party (UKIP) in Britain and the National
Front in France as voters across Europe turned to antiestablishment parties. While the main
centre-right and centre-left coalitions retained a majority in the European Parliament, EU leaders
were forced to address a strong electoral performance by parties whose stated goals were the
radical restructuring or outright elimination of the defining characteristics of the EU.
SAARC/SAPTA
The South Asian Association for Regional Co-operation (SAARC) is an organisation of South
Asian nations, which was established on 8 December 1985 when the government of Bangladesh,
Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka formally adopted its charter providing
for the promotion of economic and social progress, cultural development within the South Asia
region and also for friendship and co-operation with other developing countries.
The South Asian Association for Regional Cooperation was formed under Article 52 of the
United Nations’ Charter providing existence of regional arrangements or agencies for dealing
with such matters, relating to the maintenance of international peace and security with the
purpose and principles of UN charter.
The basic aim of the Association is to accelerate the process of economic and social development
in member countries through joint action in the agreed areas of cooperation.
It is dedicated to economic, technological, social and cultural development emphasising
collective self- reliance. In terms of population, its sphere of influence is the largest of any
regional organisation: almost 1.5 billion combined population of its member states. In April
2007, Afghanistan became its eighth member.
Objectives of SAARC:
The objectives of SAARC, as defined in its charter, are as follows:
i. Promote the welfare of the peoples of South Asia and improve their quality of life;
ii. Accelerate economic growth, social progress and cultural development in the region by
providing all individuals the opportunity to live in dignity and realise their full potential;
iii. Promote and strengthen collective self-reliance among the countries of South Asia;
iv. Contribute to mutual trust, understanding and appreciation of one another’s problems;
v. Promote active collaboration and mutual assistance in the economic, social, cultural, technical
and scientific fields;
vi. Strengthen co-operation with other developing countries;
vii. Strengthen co-operation among themselves in international forms on matters of common
interest; and
viii. Cooperate with international and regional organisation with similar aims and purposes.
SAARC Preferential Trading Arrangements (SAFTA):
The South Asian Association for Regional Cooperation was formed on 8th December 1985 as
the first step towards regional corporation. In 1995 a decade after the formation of SAARC, the
South Asian Free Preferential Trading Agreement (SAPTA) was launched at the end of year. The
year 2001 was declared as the deadline to finalise a treaty for the South Asian Free Trade
Association (SAFTA). The SAARC seven countries signed a treaty that would lead to free trade
and movement of goods paving the way for South Asian Economic Union along the lines of EU
in future.
The South Asian Free Trade Association (SAFTA), in the treaty seeks to remove trade barriers,
phased elimination of tariffs and establishment of a ministerial level mechanism for
administering the treaty and dispute settlement among members. This treaty was to come into
operation by January 1, 2006. In fact, the exchange of mutual experience among the countries is
more relevant, cheap and cost effective and provides a vast scope for mutual cooperation in
various areas. Mostly agriculture will continue to dominate these economies for many years to
come. The economy development such as food for growing population, fodder for livestock, raw
material and market for industries are the main market goods.
SAPTA which came into operations in’1995 heralds a new chapter of economic co-operation
among the SAARC countries. IT concretises the first step towards creation of a trade bloc in the
South Asian Region. Under the SAPTA mechanism, the SAARC countries, to begin with, have
identified 226 items for exchange on tariff concessions ranging from 10 per cent to 100 per cent.
India has agreed to extend tariff concessions on 106 items, while Bangladesh has agreed to offer
tariff concessions on 12 items, Maldives on 17, Nepal 14, Pakistan 35, Sri Lanka 31 and Bhutan
11. Out of 106 items offered by India for tariff concessions, 62 items would be for the least
developed countries in the SAARC.
SAPTA to SAFTA:
The South Asian Free Trade Area (SAFTA) agreement came into force from July 1, 2006. With
this, the earlier SAPTA established in 1995 had paved the way to SAFTA. The South Asian
developed countries are well endowed with labour and natural resources.
Further, with growing openness among themselves, higher production and expansion of labour,
intensive exports, increased employment, increased wages and thereby helping in reducing
poverty, the region is poised to play an important role in the growing international trade
relations.
ASEAN (Association of South-East Asian Nations)
The Association of Southeast Asian Nations (ASEAN) is a geo-political and economic
organization of ten countries located in Southeast Asia. On 8th August 1967 ASEAN was
formed by five countries Indonesia, Malaysia, the Philippines, Singapore and Thailand.
Since then, membership has been expanded to include Brunei, Burma (Myanmar), Cambodia,
Laos and Vietnam. Aims of ASEAN mainly include—accelerating economic growth, social
progress, cultural development among its members, protection of regional peace and stability,
and opportunities for member countries to discuss their differences peacefully for its settlement.
ASEAN covers a land area of 4.46 million km which is about 3.0 per cent of the total land area
of earth. It gives shelter to approximately 600 million people which is about 8.8 per cent of total
population of the world. Total sea area of ASEAN is about three times larger than its land
counterpart.
In 2010, the combined nominal GDP of ASEAN had grown to US $ 1.8 trillion. If ASEAN is
taken as a single entity, it will rank as the ninth largest economy in the world, behind the United
States, China, Japan, France, Germany, Brazil, the United Kingdom, and Italy.
The ASEAN Way:
In order to implement independent policies with a unifying focus of refrain from interference in
regional domestic affaires, there was a move to unify the South East Asian region under what
was called the ‘ASEAN Way’.
on the ideals of non-interference, informality, minimal institutionalization, consultation and
consensus, non-use of force and non-confrontation. ASEAN members approved the popular term
‘ASEAN Way’ in order to describe a regional method of multilateralism.
Thus a Treaty of Amity and Co-operation was signed in Southeast Asia and adopted the
following fundamental principles:
(i) Mutual respect for the independence, sovereignty, equality, territorial integrity, and national
identity of all nations.
(ii) The right of every State to lead its national existence free from external interference.
(iii) Non-interference in internal affaires.
(iv) Settlement of differences or disputes in a peaceful manner.
(v) Renunciation of the threat or use of force.
(vi) Attaining effective regional cooperation.
Thus the ‘ASEAN Way’ is contributing durability an longevity within the organisation, by
promoting regional identity and enhancing a spirit of mutual confidence and cooperation.
ASEAN agreements are negotiated in a close, interpersonal process.
Such process of consultations and consensus is designed to engender a democratic approach to
decision making. These leaders are wary of any effort to legitimize efforts to undermine their
nation or contain regional cooperation.
Critics argue that ASEAN way serves as the major stumbling block to it becoming a true
diplomacy mechanism. As a result of consensus based approach every member has a veto and
thus contentious issues must remain unresolved until agreements can be reached.
Moreover, it is usually, claimed that member nations are directly and indirectly advocating that
ASEAN be more flexible and allow discourse on internal affaires of member countries in
effective manner.
India and ASEAN—A Partnership:
The partnership between India and the Association of South East Asian Nations (ASEAN)
comprising Brunei, Cambodia, Indonesia, Laos, Myanmar, Malaysia, the Philippines, Singapore,
Thailand and Vietnam has been developing smoothly at a fast pace since its inception.
In 1992, India became a sectoral dialogue partner of ASEAN. Mutual interest led ASEAN to
invite India to become its full dialogue partner during the fifth ASEAN Summit held in Bangkok
in 1995. India also become a member of the ASEAN Regional Forum (ARF) in 1996. Since
2002, India and ASEAN have been holding summit level meraling on an annual basis since
2002.
India then signed a Free Trade Agreement (FTA with the ASEAN members in Thailand in
August, 2009. Under the ASEAN—India FTA, member countries of ASEAN and India will lift
import tariff on more than 80 per cent of traded products between 2013 and 2016, as reported by
the Ministry of Commerce and Industry.
In January 2010, Singapore, Malaysia and Thailand accepted FTA on goods. Other seven
ASEAN countries have also operationalist the FTA in the mean time.
Moreover, India and ASEAN are currently negotiating agreements on trade in services and
investment. Negotiation on trade in services are taking place on a request-offer basis, where both
sides make requests for the openings they seek and offers are made by the receiving country
based on the requests.
In the meantime, India made requests in a number of areas including teaching, nursing,
architecture, Chartered Accountancy and medicine as it has a large number of English speaking
professionals in these above mentioned areas who can gain satisfactoriness from job
opportunities in the ASEAN region India is also seen on expanding its telecom, IT, tourism and
banking network among the ASEAN member countries.
Buoyancy in Trade and Investment:
In the mean time, ties between India and ASEAN has been established on a solid footing. The
deepening of ties between India and ASEAN is reflected in the continued buoyancy in trade
figures. India’s trade with ASEAN countries increase from US $ 30.7 billion in 2006-07 to US $
39.08 billion in 2007-08 and to US $ 57.87 billion in 2008-09.
In 2010-11, India’s exports to ASEAN totalled US $ 27.27 billion. Again India imported goods
worth US $ 30.6 billion in 2010-11 from ASEAN.
In recent years, the growing bilateral economic relationship is reflected in the rapidly rising
bilateral trade between Singapore and India. Singapore continue to be the single largest investor
it) India amongst the ASEAN countries and also becomes the second largest among all countries
in respect of inflow of foreign direct investment (FDI) into India, totalling US $ 2.4 billion in
2009-10.
The cumulative FDI inflows from Singapore during the period April 2000 to March 2010 were
US $ 10.2 billion, as per data released by the Department of Industrial Policy and Promotion
(DIPP). Total bilateral trade during 2008-09 was US $ 16.1 billion, showing an increase of 3.86
per cent over US $ 15.5 billion in 2007-08.
During 2008-09, India exported goods work US $ 8.45 billion to Singapore, comprising mainly
of mineral fuels and oils, ships, boats and floating structures and natural pearls, gems and
jewellery.
Recently, India has signed the Free Trade Agreement (FTA) in services and investments with 10
member ASEAN countries, which has paved the way for free movement of professionals and
further opening up of opportunities for investment among the agreeable countries.
Since India had already implemented foreign trade agreement in goods and commodities with the
ASEAN in 2011, the FTA with them has now become full fledged. Thus, it is happy to note that
the trade in services agreement contains all features of a modern and comprehensive pact and is
in line with bilateral agreements that India has signed so far.
The ASEAN noted that the total two way trade between ASEAN and India grew by 5.3 per cent
in the past years and called for further encouragement and promotion of business-to-business
contact in order to achieve greater volume of trade and investment.
The bilateral trade between India and ASEAN grew by 4.6. per cent from USD 68.4 billion in
2011 to USD 71.6 billion in 2012. ASEAN’s exports were valued at USD 43.84 billion and
imports from India amounted to USD 27.72 billion in 2012. The target has now been set for
ASEAN India trade to the extent of USD 100 billion by 2015.
In order to achieve its target, India stressed the need for strengthening of maritime connectivity
with Myanmar, Thailand, Cambodia and Vietnam and also called for an ‘open sky policy’ on
quid pro quo basis in order to increase its trade with ASEAN.
20th India—ASEAN Commemorative Summit, 2012:
On the historic occasion of the 20th Commemorative year of the ASEAN-India relations, the
Ministry of External Affaires, Government of India and the Confederation of Indian Industry
(CII) organised the ASEAN- India car Rally, 2012 from November 25 to December 20 in close
cooperation with member states of ASEAN and the ASEAN Secretarial.
The rally started as Yogyakarta in Indonesia and traversed nine nations and entered India through
March the border point in Manipur and after reaching Guwahati the rally finally culminated at
New Delhi. The ASEAN-India car Rally, 2012 conceived to mark yet another meaningful step
forward in the ASEAN-India relations.
This has successfully demonstrated proximity between India and ASEAN countries, created
public awareness of India-ASEAN relations, promoted connectivity, especially road transport
and would likely to enhance trade, investment, tourism and people to people contact between
India and ASEAN countries.
The business marker events mainly focused on the North East Connectivity, IT and ITeS,
mining, agriculture, small and medium enterprises (SMEs) border trade, investment and
financing, infrastructure and development etc.
3.10. SUMMARY
International trade is important for all countries from the growth point of view. However some
countries lacks expert who could help in implementing rules that are beneficial for the countires.
These organisations help to overcome all problems and have played a major role in developing
the economies of the countries. Further they have given a platform for the world to come
together and sit and discuss. They have come up with various policies that promote international
trade.
3.11. ANSWER TO CHECK YOUR PROGRESS
The General Agreement on Tariffs and Trade (GATT), which was signed in 1947, is a
multilateral agreement regulating trade among 153 countries. According to its preamble, the
purpose of the GATT is the "substantial reduction of tariffs and other trade barriers and the
elimination of preferences, on a reciprocal and mutually advantageous basis."
World Trade Organization (WTO) came into existence on January 1, 1995, as a result of the
Uruguay Round of Trade Negotiations.
The TRIPS Agreement, which came into effect on 1 January 1995, is to date the most
comprehensive multilateral agreement on intellectual property.
The South Asian Association for Regional Co-operation (SAARC) is an organisation of South
Asian nations, which was established on 8 December 1985 when the government of Bangladesh,
Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka formally adopted its charter providing
for the promotion of economic and social progress, cultural development within the South Asia
region and also for friendship and co-operation with other developing countries.
3.12. QUESTIONS AND EXERCISES
1. Discuss the Tokyo round of negotiations under GATT.
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2.Discuss the role of SAARC in promoting regional trade
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3. Discuss the various provisions of GATT
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4. Write a brief note of WTO and its role in promoting international trade
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