Global Business Environment - Module 2: International Trade Theories PDF

**Course Name: Global Business Environment** **Module 2: International Trade Theories** **[Mercantilism]** Mercantilism is an economic theory and practise where the government seeks to regulate the economy and trade in order to promote domestic industry -- often at the expense of other countries....

**Course Name: Global Business Environment** **Module 2: International Trade Theories** **[Mercantilism]** Mercantilism is an economic theory and practise where the government seeks to regulate the economy and trade in order to promote domestic industry -- often at the expense of other countries. Mercantilism is associated with policies which restrict imports, increase stocks of gold and protects domestic industries. Mercantilism stands in contrast to the theory of free trade -- which argues countries economic well-being can be best improved through the reduction of tariffs and fair free trade. **Mercantilism involves** - Restrictions on imports: Tariff barriers, quotas or non-tariff barriers. - Accumulation of foreign currency reserves, plus gold and silver reserves. (also known as bullionism) In the sixteenth/seventeenth century, it was believed that the accumulation of gold reserves (at the expense of other countries) was the best way to increase the prosperity of a country. - Granting of state monopolies to particular firms especially those associated with trade and shipping. - Subsidies of export industries to give competitive advantage in global markets. - Government investment in research and development to maximise efficiency and capacity of the domestic industry. - Allowing copyright/intellectual theft from foreign companies. - Limiting wages and consumption of the working classes to enable greater profits to stay with the merchant class. - Control of colonies, e.g. making colonies buy from Empire country and taking control of colonies wealth. **Examples of Mercantilism** - England Navigation Act of 1651 prohibited foreign vessels engaging in coastal trade. - All colonial exports to Europe had to pass through England first and then be re-exported to Europe. - Under the British Empire, India was restricted in buying from domestic industries and was forced to import salt from the UK. Protests against this salt tax led to the 'Salt tax revolt' led by Gandhi. - In seventeenth-century France, the state promoted a controlled economy with strict regulations about the economy and labour markets. - Rise of protectionist policies following the great depression; countries sought to reduce imports and also reduce the value of the currency by leaving the gold standard. - Some have accused China of mercantilism due to industrial policies which have led to an oversupply of industrial production -- combined with a policy of undervaluing the currency. **Modern Mercantilism** - Undervaluation of currency government buying foreign currency assets to keep the exchange rate make exports more competitive. This is a criticism often levelled at China. - Government subsidy of industry for unfair advantage. Again China has been accused of offering state supported subsidies for industry, leading to oversupply of industries such as steel -- meaning other countries struggle to compete. - A surge of protectionist sentiment, e.g. US tariffs on Chinese imports, and US policies to 'Buy American.' - Copyright theft **Criticisms of Mercantilism** - Adam Smith's "The Wealth of Nations" (1776): Argued for benefits of free trade and criticised the inefficiency of monopoly. - Theory of comparative advantage(David Ricardo) - Mercantilism is a philosophy of a zero-sum game, where people benefit at the expense of others. It is not a philosophy for increasing global growth and reducing global problems. Also, increasing other peoples wealth can lead to selfish benefits, e.g. growth of other countries, increases markets for our exports. Trying to impoverish other countries will harm our own growth and prosperity. - Mercantilism which stresses government regulation and monopoly tends to lead to inefficiency and corruption. - Mercantilism justified Empire building and the poverty of colonies to enrich the Empire country. - Mercantilism leads to tit for tat policies: High tariffs on imports leads to retaliation. - The growth of globalisation and free trade during the post-war period showed possibilities from opening markets and respecting other countries as equal players. - Economies of scale from specialisation possible under free trade. **Justification for neo-mercantilism** Despite many criticisms of mercantilism, there are arguments to support the restriction of free trade in certain circumstances. - **Tariffs in response to domestic subsidies.** Supporters argue that since China's steel is effectively subsidised leading to a glut in supply, it is necessary and fair to impose tariffs on imports of Chinese steel to protect domestic producers from unfair competition. US tariffs on imports of steel from China 266%. In Europe, tariffs are 13%. - **Protection against dumping**. If some countries have an excess supply of goods, they can sell at a very low price to get rid of the surplus. But, this can make domestic firms unprofitable. Protectionism can be justified to protect against this dumping. Examples, include EEC dumping excess agricultural production on world agricultural markets and China's dumping of steel. - **Infant industry argument.** For countries seeking to diversify their economy, tariffs may be justified to try and develop new industries. When the industries have developed and benefited from economies of scale, then the tariffs and protectionism can be dropped. **[Absolute Cost Theory]** Adam Smith is generally ignored as a trade theorist in text books of international economics because of the common belief that he only confirmed the rule of absolute advantages to explain the structure of foreign trade. However, his vent-for-surplus approach may be interpreted as a pioneering study which stresses the importance of economies of scale in explaining the structure of trade. Economists recognize the undeniable influence of Smith's concepts such as "extent of the market", "division of labour", "improved dexterity in every particular workman", and "simple inventions coming from workman" on trade theory. Adam Smith propounded the theory of absolute cost advantage as the basis of foreign trade; under such circumstances an exchange of goods will take place only if each of the two countries can produce one commodity at an absolutely lower production cost than the other country. Country Commodity ----------- ----------- ---- A B Country 1 10 20 Country 2 20 10 Suppose there are two countries, I & II and two commodities, A and B. For example, country can produce a unit of commodity (A) with 10 and a unit of commodity (B) with 20 labour units, and that in country II, the production of a unit of (A) costs 20 and a unit of (15) 10 labour units. Now country I has absolute cost advantage in production of (A) and it will confine itself to the production of (A) and country II in the production of (B). Exactly the same would happen if I and II were two regions of one country. We speak of absolute differences in costs because each country can produce one commodity at an absolutely lower cost them the other. Thus, in such a situation, a division of labour between them must lead to an increase in total output. **[Comparative Cost Theory]** Eminent economists have said that the comparative cost theory is the basis of inter­national business. It explains that: **"it pays countries to specialize in the production of those goods in which they possess greater comparative advantage or the least comparative disadvantage."** In the words of Cairnes---"The difference in the comparative cost of producing the commodities exchanged is essential to, and sufficient for, the existence of international business". This is the fundamental basis of international business." When this theory is applied to international business, the theory states that a country tends to specialize in the production of those articles in which it enjoys greater comparative advantage. What is more important is not the cost of commodity in country A and its cost in country B but the ratio between the costs of the commodities in the two countries. **A Paradox Indeed:** One will be surprised to find a country importing a particular commodity from another country even when she can herself produce it at a lower cost. Why so? This can be explained by giving suitable and proper example---we find that Great Britain can produce both dairy products and machinery chapter than Denmark, yet she imports dairy products from Denmark and export machinery. Why so? This paradox can be explained in this manner. Take this point-a Professor can polish and black his own shoes better than his servant and can of course teach and lecture far better. But his time is more profitably used with his books than with brush and polish. Similarly, a doctor may be a better dispenser than his assistant, but it pays him to examine patients and leave dispensing to his compounder. In the same way Great Britain imports cheese and butter because she gains more by producing machinery. This is not a matter of surprise because every nation uses its resources in such channels which will yield the best results. This is the main basis of all international business. **Criticism of Absolute Cost Advantage Theory** Most of the criticisms from absolute advantage theory would arise because of the unrealistic nature of its assumptions. However, an important incompleteness in the theory was the fact that it addressed only a situation wherein one country enjoyed an absolute advantage in production of a commodity over another country. It was pointed out that such situations are rare. Quite often the advantage is not an absolute advantage but a comparative one as would be clear from the Ricardian Theory of Comparative Cost Advantage. **Criticism of the Comparative Cost Theory:** **1. This theory is based on wrong assumptions:** The comparative cost theory is based on some such assumptions which do not hold well in real life. **Some of these assumptions are:** \(i) Static assumptions of fixed costs, \(ii) The unit costs remain the same, \(iii) It assumes that there are no transport costs, \(iv) Fixed supplies of the factors of production etc., \(v) Further it assumes that there are no other costs except labour costs, and \(vi) It assumes perfect mobility of factors inside and perfect immobility outside the country. Economists do not believe over all these assumptions. Therefore, this theory is not applicable to real life. Thus, the international business does not follow the law of comparative cost. **2. This Theory Implies Specialization:** But in real life complete specialization is not possible nor always desirable so far as countries are concerned. **3. International Business Arises Owing to Differences in Relative Factor Prices:** But international business also tends to narrow down these differences. Hence, business should come to end if we accept comparative cost theory. **4. This Theory has been considered as One Sided:** As it ignores the demand and concentrates only on the supply side. This theory does not speak as to what prices the goods will be demanded. **5. It is not an Adequate Explanation:** The comparative cost theory does not furnish an adequate explanation of international business. **Critical Appraisal of Comparative Cost Theory:** Theory of comparative cost which is the important doctrine of classical economics is still valid and widely acclaimed as the correct explanation of international trade. Most of the criticisms that have been leveled against this doctrine relate to the Ricardian version of comparative cost theory based on labour-theory of value. Haberler and others broke away from this labour-cost version and reformulated the comparative cost theory in terms of opportunity costs which takes into consider­ation all factors. The basic contention of the theory that a country will specialize in the production of a commodity and export it for which it has a lower comparative cost and import a commodity which can be produced at a lower comparative cost by others, is based on a sound logic. The theory correctly explains the gain from trade accruing to the participating countries if they specialize ac­cording to their comparative costs. These merits of the theory have led Professor Samuelson to remark, "If theories, like girls, could win beauty contents, comparative advantage would certainly rate high in that it is an elegantly logical structure." He further writes, "the theory of comparative advantage has in it a most important glimpse of truth.... A nation that neglects comparative advan­tage may have to pay a heavy price in terms of living standards and potential rates of growth." Despite the sound logical structure and vivid explanation of gains from trade, the comparative cost theory, especially the Ricardian version based on labour theory of value has been criticized. **The following criticisms have been leveled against this theory:** 1. In the first place, Ricardian version of comparative cost theory has been attacked on the ground that being based on labour theory of value, it considers only labour cost to measure the comparative costs of various goods. It has been pointed out that labour is not the only factor needed for the production of commodities; other factors such as capital, raw materials, land also contribute to production. Therefore, it is the total money costs incurred on labor as well as other factors that should be considered for assessing comparative costs of various commodities. Taussig tried to defend Ricardo by pointing out that even if labor theory of value was defective and even if other factors made important contributions to the production of goods, comparative costs could still be based on labor cost alone, if it is assumed that the trading countries are at the same stage of technological development. This is because, he argued that given the same techno­logical development; the proportions in which other factors could be combined with labor would be the same. In view of this he asserted that other factors could be validly ignored and for purpose of comparative costs relative efficiency of labor alone of different countries could be considered. However, Taussig's defense of Ricardian version of comparative cost theory is poor and invalid. The various trading partners are not at the same stage of technological development and therefore the factor proportions used for the production of commodities in different countries are vastly dif­ferent. Hence, it is quite unrealistic and improper to consider relative efficiency of labor alone. However, as stated earlier, Haberler rescued the comparative cost theory from labor theory of value and reformulated it in terms of opportunity cost which covers all factors. 2. The comparative cost theory explained that different countries would specialize in the pro­duction of goods on the basis of comparative costs and that they would gain from trade if they export those goods in which they have comparative advantage and import those goods from abroad in respect of which other countries enjoyed comparative advantage. But it could not provide a satisfac­tory explanation of why comparative costs of producing commodities in various countries differ. Ricardo thought comparative costs of producing commodities in various countries differed due to the differences in efficiency of labor. But this begs the question why labor efficiency is different in various countries. #### #### #### **Factors for Variation in Comparative Costs of Different Commodities:** The credit of providing an adequate and valid answer to this question goes to Heckscher and Ohlin who explained that comparative costs of different commodities in the two countries vary because of the following factors: 1. The various countries differ in respect of factor endowments suited for the production of different commodities. 2. The different commodities require different factor proportions for their production. Thus Heckscher and Ohlin supplemented the comparative costs theory by providing valid reasons for differences in comparative costs in various countries. 3. Against the Ricardian doctrine of comparative cost it has also been said that it is based on the constant cost of production in the two trading countries. This assumption of constant costs leads them to conclude that different countries would completely specialize in the production of a single product on the basis of their comparative costs. Thus, of the two commodities cloth and wheat, if India has a comparative advantage in the production of cloth, it will produce all cloth and no wheat. On the other hand, if U.S.A. has a comparative advantage in the production of wheat, it will produce all wheat and no cloth. But the pattern of international trade shows that this is far from reality. As a matter of fact, a stage comes when it is no longer advantageous for India to import wheat from U.S.A. (because of increasing costs in producing wheat). Further, in the real world it is found that countries do not have complete specialization. Indeed, a country produces a certain commodity and also imports a part of it. However, it may be noted that even if the phenomenon of increasing costs is taken into account, foreign trade can still be explained in terms of differences in comparative costs. Only in the situation of increasing costs, countries would not have complete specialization. Opportu­nity cost version of comparative costs theory does consider the case of increasing costs. 4. The Ricardian theory of comparative costs has also been criticized for its not going into the question what determines the terms of trade between the countries. Voicing this criticism Elseworth remarks, "the comparative costs theorem, the way in which Ricardo set up his illustration, tended to obscure the problem of the terms of trade." Ricardian theory of comparative costs explains what commodity a country will export and what commodity it will import but it does not investigate at what rate it will exchange its exports for imports (i.e. terms of trade). However, the fixation of terms of trade is a vital issue, for on it a country's share of gains from trade depends. It is worthwhile to note that J.S. Mill, another noted classical economist, removed this shortcom­ing of the comparative cost theory by supplementing it with Reciprocal Demand Theory which explains the determination of terms of trade. 5. Ohlin attacked the comparative cost theory for its assumption that factors of production were perfectly mobile within a country but immobile between countries. He pointed out that immobility of factors between countries could not serve as a basis for international trade, since immobility of factors is not peculiar the relations between countries but is also present between different regions of the same country. He further expressed the view that comparative cost doctrine applied not only to international trade but also to inter-regional trade. Indeed, according to him, international trade is only a special case of inter-regional trade. He further criticized the classical theory of compara­tive cost for its emphasis on supply conditions as an explanation of international trade and its ne­glect of the importance of demand conditions in determining the pattern of international trade. He writes, "The comparative cost reasoning alone explains very little about international trade. It is indeed nothing more than an abbreviated account of the condition of supply". According to him, prices of different goods and their quantities produced and consumed depend on both supply and demand conditions. He therefore, propounded a new theory of international trade based on general equilibrium theory of value. It may be mentioned here that Ohlin's criticisms do not invalidate comparative cost theory. Indeed, he only refined and modified it. Even in his theory, popularly known as factor-proportions theory of international trade, comparative costs serve as a basis of international trade. His contribu­tion lies in his inquiring into the question why comparative costs of commodities in different coun­tries differ and offering a satisfactory explanation of it in terms of different factor-proportions required for the production of various goods. He further improved the comparative cost theory by incorporating in his analysis the demand aspect as be based his international trade theory on the general equilibrium theory of value. 6. It is alleged that comparative cost theory is static in character as it is based on fixed supplies of factors of production, the given technology, and the fixed and identical production functions in the trading countries. Its conclusions cannot therefore be applied in the context of a dynamic economy, especially in the present-day developing countries where resources are being developed, technology is being improved, and production functions are undergoing a change. Indeed, structural changes are being brought about in these economies. In view of the changes in factor supplies and technology in developing countries, comparative costs of producing different com­modities are also changing. In this dynamic context, a developing economy may have a comparative disadvantage in producing a certain commodity but may attain a comparative advantage after a certain stage of its development. Note that this criticism about the static character of the comparative cost theory does not invali­date it. It only pinpoints the need for reformulating and refining it so as to make it applicable to the dynamic conditions of the developing countries. #### To sum up, bereft of the labor theory of value and expressed in terms of opportunity costs comparative cost theory is still a valid explanation of international trade. It highlights the need for removal of artificial restrictions in the form of tariffs and other means on foreign trade so that various countries specialize on the basis of their comparative costs and derive mutual benefits from trade. This theory has been a victim of undue criticisms such that it assumes the absence of transport costs, the existence of perfect competition and full employment, and further that it consid­ers two commodities, two countries model. These are only simplifying assumptions and do not invalidate its conclusions in a substantial way. Indeed, every theory makes some such simplifying assumptions in order to bring out the economic forces that have an important bearing on the subject under investigation. **[Factor endowment Theory]** **The factor endowment theory** holds that countries are likely to be abundant in different types of resources. In economic reasoning, the simplest case for this distribution is the idea that countries will have different ratios of capital to labor. Factor endowment theory is used to determine comparative advantage. The Hechsher-Olin Theory holds that a country will have a comparative advantage in the good that uses the factor with which it is heavily endowed. When calculating comparative advantage, it is essential to remember that it is the ratios of factors that matter; a country could be heavily endowed with both labor and capital, but it proportionally may have more of one than another than would another country. If a country has a comparative advantage in a good that uses the factor with which it is heavily endowed, it should focus its production on that good. Because it is heavily endowed with that factor, it will be most efficient at producing the good that requires that factor for production. For example, a country with a high ration of capital to labor will be more efficient at producing computers than it would corn. If that country instead focused on producing corn, it would have to divert capital which is not meant for corn production into an area where it is inefficiently used. **Critiques of the Factor Endowment Theory** The factor endowment theory, while used to explain overarching notions of comparative advantage, in reality only accounts for a small percentage of world trade. At one time, there were big disparities between labor and capital in the US and East Asia. East Asia began to grow much faster than the US, however trade increased as the two countries became more similar, even though the factor endowment theory would predict that trade should have lessened. This suggests that there must be something other than factor endowments motivating international trade. The assumptions that drive the factor endowment theory may be flawed. It first assumes the same technology, and also assumes arbitrary borders. However, factors like borders play a large role in how much trade occurs; Seattle, for instance, conducts more trade with Boston than it does with Vancouver. Branding also plays a large role in trade; France has been very successful in differentiating its product, wine, from that of other countries, so regardless of factor endowments France will likely continue to specialize in wine and the rest of the world will likely keep buying it from them. **[International Product Life Cycle]** **The International Product Life Cycle Theory** was authored by Raymond Vernon in the 1960s to explain the cycle that products go through when exposed to an international market. The cycle describes how a product matures and declines as a result of internationalization. There are three stages contained within the theory. ### New Product Introduction The cycle always begins with the introduction of a new product. In this stage a corporation in a developed country innovates a new product. The market for this product will be small and sales will be relatively low as a result. Vernon deduced that innovative products are more likely to be created in a developed nation because the buoyant economy means that people have more disposable income to use on new products. To offset the impact of low sales, corporations will keep the manufacture of the product local, so that as process issues arise or a need to modify the product in its infancy stage presents itself, changes can be implemented without too much risk and without wasting time. As sales increase, corporations may start to export the product out to other developed nations to increase sales and revenue. It's a straightforward step towards the internationalization of a product because the appetite of people within developed nations tends to be quite similar. ### The Maturity Stage At this point, when the product has firmly established demand in developed countries, the manufacturer of the product will need to consider opening up production plants locally in each developed country to meet the demand. As the product is being produced locally, labor costs and export and costs will decrease thereby reducing the unit cost and increasing revenue. Product development can still occur at this point as there is still room to adapt and modify the product if needed. Appetites for the product in developed nations will continue to increase in this stage. Although the unit costs have decreased due to the decision to produce the product locally, the manufacture of the product will still require a highly skilled labor force. Local competition to offer alternatives start to form. The increased product exposure begins to reach the countries that have a less developed economy, and demand from these nations start to grow. ### Product Standardization and Streamlining of Manufacturing Exports to nations with a less developed economy begin in earnest. Competitive product offers saturate the market which means that the original purveyor of the product loses their competitive edge on the basis of innovation. In response to this, rather than continuing to add new features to the product, the corporation focuses on driving down the cost of the process to manufacture the product. They do this by moving production to nations where the average income is much lower and standardizing and streamlining the manufacturing methods needed to make the product. The local workforce in lower income nations are then exposed to the technology and methods to make the product and competitors begin to rise as they did in developed nations previously. Meanwhile, demand in the original nation where the product came from begins to decline and eventually dwindles as a new product grabs the attention of the people. The market for the product is now completely saturated and the multinational corporation leaves the manufacture of the product in low income countries and instead, focuses its attention on new product development as it bows gracefully out of the market. What is left of the market share is divided up between predominantly foreign competitors and people in the original country who want the product at this point, will most likely buy an imported version of the product from a nation where the incomes are lower. Then the cycle begins again. topic 4 Advertisements **[International Investment Theory:]** **Theory of Capital Movements** The international trade and the movements of productive resources such as labour, capital and technology are substitutes for one another. A relatively capital-abundant country like the United States can export either capital-intensive commodities or export capital itself. The conditions of capital-scarce countries require them to either import capital-intensive goods or procure the desired flow of capital from abroad. The movement or flow of financial resources from one country to another either for the adjustment of BOP disequilibrium or for expanding the production frontier in a country denotes international capital flow or movement. It is necessary to distinguish the international capital movements from the payments for imports. The capital movements may either be meant for financing the deficits in the BOP or for bringing about a net increase in productive capacity in the economy. In the latter situation, the international capital movements can be treated as a factor of production. If the sufficient inflow of capital fails to take place from abroad, the productive activity is likely to be adversely affected. In this connection, it must be recognised that only real capital movements are significant from the point of view of the allocation of resources. It means the countries depending on the inflow of foreign capital to maintain and/or to raise the level of economic activity should have capital inflow of the magnitude which is more than the offset of the domestic price movements. The international capital movements have continued to take place over centuries. Historically, the development of Britain, the U.S.A., Canada, Australia and many other countries took place by virtue of foreign capital. The century preceding World War I was the "golden age" of private investment activity. During that period, Britain, the United States, France and Germany became increasingly industrialised through large scale foreign investments. Apart from these countries, the recipients of foreign investment during that period included several countries of Europe, Latin America, Canada, Asia and Africa. During the inter-war period, the major development was that the United States got transformed from a net international debtor into a significant net creditor country. The depression of 1930's caused a sharp decline in the international trade and capital movements on account of disorganization of international monetary apparatus and intensification of tariff, trade and exchange restrictions. In the decade of 1930's, there were extensive defaults on interest and amortization payments due from foreign borrowers, both private and governmental. During the period after Second World War, there has been a substantial increase in the capital flow from the advanced to the LDCs. These capital movements have taken place on private account through multinational corporations (MNCs), on bilateral government to government basis and on multilateral basis through international monetary and financial institutions such as World Bank, International Monetary Fund, International Finance Corporation and the regional financial institutions like the Asian Development Bank. **Classification of International Capital Movements:** **(i) Home and Foreign Capital:** The investments undertaken by the residents of the home country in foreign countries denote the home capital. On the opposite, the investments undertaken by the foreigners in the home country signify the foreign capital. In the first case, there is a movement of capital from home country to abroad and in the latter case, there is a capital movement from abroad to the home country. In the BOP account, the inflow of capital from abroad is the credit item whereas the outflow of capital to foreign countries is the debit item. The difference between the debits and credits on account of capital movements represents the net foreign investment which may be either positive or negative. **(ii) Government and Private Capital:** The government capital refers to the lending and borrowing from foreign countries by the government of a given country. On the opposite, the lendings made by the private individuals and institutions to the foreigners and borrowing by them from abroad signify the private capital. The private capital transfers from one country to another are many often guaranteed by the government or central bank of the borrowing country. **(iii) Short-Term and Long-Term Capital:** Short-term international capital movements consist of such credit instruments that have a maturity of less than one year. The short term capital movements can take place through currency, demand deposits, bills of exchange, commercial papers and time deposits up to a maturity of one year. The short-term capital movements bring about some important changes in the money supply of a country. These changes take place in the forms of primary, secondary and tertiary effects- Firstly, the capital movements can result in the BOP deficit or surplus. If there is a BOP deficit, there is some contraction in domestic money supply. On the contrary, the BOP surplus results in an expansion in money supply. These changes in money supply represent a primary change. Secondly, the short-term capital movements can cause changes in the reserve position of the commercial banks. As the reserves get affected, there can be changes in the capacity of those banks to expand or reduce deposits and credits. These can be considered as secondary changes in money supply. In this connection, however, an assumption has been made that the commercial banks do not already have excess reserves with them. Thirdly, the short term capital movements can cause variations in the reserves of a central bank. If the central bank of a country operates on the basis of its reserves and it is ready to expand open market investments in the event of an expansion in its reserves and vice-versa, there can be changes in money supply. Such changes can be treated as the tertiary changes in the supply of money. Both under gold and inconvertible paper standards, the short-term capital movements resulted from the international differentials in the rates of interest. The interest rate movements induce the speculators to undertake investments or disinvestments in the foreign exchange markets to make speculative gains. In this connection, it is presumed that the central bank, commercial banks and other institutions in the money market are willing to take risk and speculate on the basis of their expectations concerning the variations in the rates of interest in different countries. Whether the short-term capital movements induced by the activities of speculators will have a destabilising or stabilising effect depends upon the extent of interest rate and discount rate differences and expectations of the speculators concerning the future changes in the interest and discount rates. The long-term capital movements take place through credit instruments having a maturity of more than one year. Long-term capital movements occur through the purchase or sale of long term securities or bonds. These sales or purchases may be undertaken by the individuals or corporations in the foreign countries or by foreign individuals or corporations in the home country. The long- term capital movements may also take place in the form of loans procured from the international financial institutions such as IMF and IBRD. **(iv) Direct and Portfolio Capital:** Foreign direct investment (FDI) means the direct investment by foreign capitalists and business institutions in other countries. The essence of foreign direct investment is that the ownership, control and management of business are vested with the foreign investors. The foreign direct investments can assume different forms: \(a) The formation of a concern in which the foreign investors or foreign companies have a majority share. \(b) The formation of a subsidiary of a concern of the investing country in the capital-importing country. \(c) The organization of a firm in the capital-importing country that is financed fully by some established concern in the investing country. \(d) The creation of fixed assets by the nationals of the investing country in the capital-importing country. \(e) The setting up of an autonomous corporation by the investing country for the specific purpose of operating other concerns. Such concerns or firms which operate in different countries and are under a centralized management are termed as transnational corporations (TNCs) or multi-national corporations (MNCs). Portfolio investment or portfolio capital consists mainly of investment in the form of holding of transferable securities, shares or debentures by the foreign investors. In case of this type of investment, the foreign investors have only the ownership of capital. The control and management rests with the capital-importing country. The foreign investors are entitled to dividends or interests on their holdings of equities, bonds or debentures. The capital-importing countries naturally have a preference for portfolio investments, whereas the investing countries have a preference for the foreign direct investments. Factors Influencing International Capital Movements: **(i) Rate of Interest:** Changes in capital both in short and long periods are greatly influenced by the changes in the rates of interest (short or long rates). The capital flow takes place from a country where the interest rates are low to those countries where the interest rates are relatively high and vice-versa. Ohlin affirmed that the difference in interest rates between countries is perhaps the most important stimulus to export and import of capital. **(ii) Marginal Efficiency of Investment:** If the expected rate of return over cost related to a given dose of investment in foreign country is higher compared with the rate in home country, there will be outflow of capital to the foreign country. On the opposite, the lower expected rate of return over cost or the marginal efficiency of investment (MEI) than in the home country will result in an inflow of capital from abroad. **(iii) Bank Rate:** The variations in bank rate by the central bank have effect upon the structure of interest rates in the money market. An increase in bank rate in the home country will cause a rise in both short-term and long-term interest rates. As these rates rise higher than the corresponding rates in the foreign countries, the home country will be able to attract short-term and long-term capital flows from abroad. A reduction in bank rate will lower the short and long term interest rates. As these rates fall below the levels of interest rates abroad, there will be outflow of capital to foreign countries. **(iv) Speculation:** The speculative activities of the operators in the exchange market can also result in capital movements. Speculation may be with respect to either interest rates or exchange rates. When speculators anticipate a rise in interest rates in the home country relative to such an expectation abroad, the security prices are expected to fall by a greater extent in the home country than abroad. This will make the speculators transfer funds from home country to abroad. If the interest rates in home country are expected to fall more than in foreign country, the speculators will transfer funds from the foreign countries to the home country. The speculation in exchange rates too influences capital movements between the countries. If the currency of home country is expected to depreciate, the speculators will move funds from the home country to the foreign country, the currency of which is expected to rule stronger. An anticipated devaluation is likely to induce the flight of capital from the devaluing country. There is a greater possibility of such capital flight when variation in exchange rates can take place freely rather than within a narrow band. On the opposite, if the speculators anticipate a revaluation (a rise in exchange rate of home currency relative to foreign currency) of the home currency, the inflow of capital may take place from abroad. **(v) Foreign Capital Policy:** The capital movements are affected also by the foreign capital policy of the government of a country. If there is regime of restrictions upon foreign capital, the inflow of foreign capital will remain clogged. On the opposite, a liberal policy in this regard can induce a substantial inflow of capital from the foreign countries. **(vi) Economic and Political Conditions:** If a country has well-developed economic infrastructure, including means of transport and communications, power, market structures and financial institutions, along with political stability, peace, law and order, the foreign investors are induced to undertake investments in the home country in a larger measure. However, if such economic and political conditions do not exist, there will be little possibility of inflow of foreign capital. There is rather a danger that even the indigenous investors will prefer to invest in foreign countries resulting in a flight of capital. **(vii) Exchange Control Policy:** The existence of stiff exchange control measures tend to prevent the inflow of capital from abroad and also adversely affect the flow of trade. A liberal policy in this respect can be more helpful in the expansion of trade and induce the inflow of capital to the home country. **(viii) Tax Policy:** If the tax rates on personal incomes and corporate profits are high, the foreign investments, both direct and portfolio are likely to be discouraged. The lower tax rates, on the other hand, can have a stimulating effect upon the capital inflow from abroad. **Market imperfections Theory** Market imperfections arise from violating the assumptions of perfect competition as described in neoclassical economics. The neoclassical market model ensures an efficient allocation of all goods and incomes. Moreover, competing vendors can build their business strategy on the equilibrium price because nobody will be motivated to offer or buy products at a different price. However, vendors in real markets have to cope with departures from these assumptions.  Four types of market imperfections can be identified: 1. Frequently, only a few suppliers compete in a market or the number  of customers  is fewer than  many. In the first case, the models of oligopolistic or monopolistic competition become effective (e.g., Stackelberg pricing or Bertrand pricing); in the latter case, vendors face an oligopsony or a monopsony. 2. Other violations arise from the heterogeneity of products. The explicit goal of all branding strategies---but also all references to the country of origin and  offering superior  services---aims to create  market  imperfections.  Consequently, if the measures  are successful, marketing  strategies introduce  market imperfections. 3. A third source of market imperfections arises from entry barriers, which frequently become a  relevant  condition   in  the  internationalization or even globalization of business activities. Already in the 18th century, Adam Smith and David Ricardo proved that international trade is useful, increases welfare, and extends production possibilities. Ignoring these basic insights, national governments do their utmost to protect their national vendors from international competitors by various means such as customs, or enforcing national engineering standards. However, vendors can create entry barriers themselves by, for instance, building product facilities with the capacity to meet, or even exceed, all the local demand. An incumbent would fear a price war if the already established vendors needed to operate with full capacity load to cope with fixed costs or benefit from economies of scale. 4. The fourth type of imperfections relates to information availability in real markets. Under perfect competition, the equilibrium price, margin profits, and margin cost are known to both sellers and buyers. In reality, the prices differ in terms of time and location, as well as with the heterogeneity of products.  It is mainly the consumers who lack precise price knowledge as well as the ability (or the willingness) to take on the mental burden of acquiring and processing complete price information. The emergence of specialized price comparisons for technical durables on the World  Wide Web (e.g., priceline.com)  reduces, but by no means solves, the problem generally. These imperfections are utilized for building management  theories  on two aggregation levels: (1) explaining strategic  actions  of competing  organizations (e.g., "cross and counter" or "follow the leader"), and (2) explaining the existence of the multinational enterprise  itself and the internationalization of business activities. A basic element for the explanation of multinational enterprises is foreign direct investment: investment  in building physical manufacturing,  distribution,  or service-providing facilities in a country different from the firm's home country.  These differ from usual portfolio investments  with respect to the aims of the investment.  Portfolio investments target arbitrage between different markets, for instance, different rates of interests or the reduction of risks by diversification to markets that are not perfectly positive correlated. In his seminal work, Steven H. Hymer emphasized the importance of direct control, which enables the creation of market imperfections, particularly the elimination of competitive attacks or responses. Hymer  argues  that  a total  fusion  of two  competing firms might maximize profits if (1) the firms are actual  or  potential  competitors and  (2) the  entry barriers  for  the  markets  under  consideration   are high and the number of competing vendors is small. Otherwise, a monopolistic advantage of the cooperating incumbents would be threatened by the entry of new vendors. In this theoretical development, foreign firms are assumed to be at a disadvantage when entering foreign markets because domestic competitors might have more detailed knowledge of national laws, a better understanding of consumer preferences, and so on. Thus, foreign competitors always have to incur higher information costs. In addition, they have to cope with currency fluctuations and are always in danger of incurring superfluous costs due to cultural misunderstandings. Multinational enterprises emerge if the monopolistic advantages derived by direct control over foreign investments at least compensates for disadvantages. Charles P. Kindleberger extended this theory of market imperfections by rigidities in the factors markets. If factors are not accessible to competitors or transferable to foreign markets, the multinational firms benefit from these rigidities. Technologies or product designs might be protected by patents; workers' wages may show substantial differences, and even the interest to be paid for credits may vary across national markets. These factor rigidities provide multinational firms with potential advantages if they locate the production facilities in different nations. This perspective enables the explanation of cross-border vertical integration in addition to horizontal integration already considered by Hymer. Moreover, the Kindleberger extension also allows the consideration of governmental restrictions of market entries and governmental trade barriers. Criticism of this theoretical development has resulted in several innovative management theories. For instance, the market   imperfection   arguments are static in time. Knowledge-based monopolistic advantages are usually dynamic advantages by nature, because innovative technologies emerge and create markets or replace older technologies in the course of time. This critique resulted in the concept of the international product life cycle. **Internationalization Theory** Internalization theory focuses on imperfections in intermediate product markets. Two main kinds of intermediate product are distinguished: knowledge flows linking research and development (R&D) to production, and flows of components and raw materials from an upstream production facility to a downstream one. Most applications of the theory focus on knowledge flow. Proprietary knowledge is easier to appropriate when intellectual property rights such as patents and trademarks are weak. Even with strong protections firms protect their knowledge through secrecy. Instead of licensing their knowledge to independent local producers, firms exploit it themselves in their own production facilities. In effect, they internalise the market in knowledge within the firm. The theory claims the internalization leads to larger, more multinational enterprises, because knowledge is a public good. Development of a new technology is concentrated within the firm and the knowledge then transferred to other facilities. **Refinements** Internalization occurs only when firms perceive the benefits to exceed the costs. When internalization leads to foreign investment the firm may incur political and commercial risks due to unfamiliarity with the foreign environment. These are known as 'costs of doing business abroad', arising from the 'liability of foreignness'. When such costs are high a firm may license or outsource production to an independent firm; or it may produce at home and export to the country instead. Firms without special knowledge may become multinational to internalise supplies of components or raw materials in order to guarantee quality or continuity of supply, or for tax advantages from transfer pricing. **Variants** Buckley and Casson (1976) was a seminal work. Two Canadian economists, Stephen Hymer and John McManus, independently noted the relevance of internalization, and their contribution is the subject of debate. Alan M. Rugman linked internalization theory to his earlier work on market imperfections, applying it empirically in a North American context. Jean-Francois Hennart subsequently developed a variant of the theory that emphasised the interplay of headquarters authority and local autonomy within the firm. Internalization theory is also closely related to Stephen Magee's appropriability theory. **Controversies** Internalization theory was used by John Harry Dunning as one of the components of his eclectic paradigm or OLI model. Dunning referred to knowledge as an 'ownership advantage' and claimed that ownership advantage was necessary for a firm to become a multinational. This was disputed by internalization theorists on the grounds that if quality control and transfer pricing are sufficient, then ownership advantage cannot be necessary. Dunning argued that the firm's ability to internalise could also be described as an ownership advantage, which led internalization theorists to suggest that his concept of ownership advantage had become tautological. Internalization theory is related to transaction cost theory through common dependence on the seminal work of Ronald Coase. They are not the same however. Internalization theory focuses on links between R&D and production whereas transaction cost theory focuses on links between one production facility and another. Transaction cost theory typically attributes market imperfections to bounded rationality and 'lock in', whilst internalization theory emphasises asymmetric information and weaknesses in property rights. Transaction cost theory is typically applied in a domestic context, whereas internalization theory was developed specifically for an international context. **Links to international business theory** Prior to internalization theory, the study of international business was largely focused on the environment, and in particular the economic, financial, political and cultural dimensions of doing business abroad. Internalization theory provided a theory of the international firm and thus augmented the international business field by demonstrating the interaction between the external environmental and the internal knowledge flows between MNE parent firm and subsidiaries. This interaction between external country-specific advantages (CSAs) and internal MNE firm-specific advantages (FSAs) is the nexus for strategic managerial international business decisions. **Location specific Advantage Theory** **Multinational corporations (MNCs)** have been relocating portions of their global supply chain to developing countries, including India and China, to generate efficiencies and remain competitive in the marketplace. Moreover, the vast consumer base in India and China, and the lowering of trade barriers have allowed MNCs to sell their products in these countries, sometimes at premium prices. As a result, the tax authorities in these countries have argued that their unique market features deserve separate recognition and compensation through appropriate transfer prices. The issue gets complicated because the option of relocating portions of a global supply chain in different countries is often available only to global MNCs and not to local, independent companies. Hence, there is a lack of available third-party data that may provide a basis for separately determining how LSAs are treated in arm's-length conditions. This issue is at the heart of the current debate on LSAs. The BRICS block of countries has assumed significant relevance in the current global business environment because they house 40% of the global population, hold an estimated \$4.4 trillion of foreign exchange reserves, and contribute 20% to global GDP. Transfer pricing developments in these economies have the potential to affect the operations and profitability of MNCs in significant ways. Hence, it is important to understand the LSA concepts being discussed and work toward consensus on how to identify, quantify, and allocate income arising from such LSAs. LSAs are those location-specific market features and/or factors of production that enable a firm to achieve an improved financial outcome from the provision of the same product or service compared to alternative locations. They may include access to skilled labor, incentives, market premiums, access to growing markets, superior infrastructure, and cost savings. ### OECD, UN, and US views of LSAs The OECD first acknowledged and addressed the issue of location savings in the new Chapter IX on transfer pricing issues associated with business restructurings that was incorporated into the OECD's transfer pricing guidelines in 2010 by stating: In the same section, the OECD transfer pricing guidelines provide examples that essentially argue that of the two entities engaged in trade, the entity that has the bargaining power, which in itself is driven by ownership of intangibles, will be able to claim the location savings. Subsequently, the OECD added a new section in its July 2013 draft of the chapter on intangibles dealing with the transfer pricing treatment of local market features, location savings, assembled workforce, and group synergies. The OECD has proposed a position acknowledging the presence of LSAs in MNC operations, but has emphasized that quantifying and allocating such benefits must be done in accordance with the arm's-length principle. It goes on to state that LSAs are comparability factors that should be considered in transfer pricing analyses, but are not in themselves intangible assets (but can involve intangible assets in certain situations). Moreover, sharing LSAs between group companies is best done through a comparability analysis, if the savings are not passed on to third-party customers. The tax authorities of India and China formally laid out their position on LSAs in a separate chapter of the UN Transfer Pricing Manual that was released October 2012, departing from the quasi-consensus position on this issue the UN presented in the other chapters in the manual. The US recognizes the concept of location savings (as opposed to other types of LSAs) in Treas. Reg. §1.482-1(d)(4)(ii) of the transfer pricing regulations, which states that if the comparable company operates in a different geography, adjustments may be required for differences in the cost of resources, while considering the competitive position of the buyer and seller. In summary, the OECD, the UN, and the US all recognize LSAs (or location savings) as an important factor in transfer pricing analysis, but reiterate their reliance on the arm's-length standard explicitly, stating that such factors are not separately compensable but should be dealt with as a part of the comparability analysis. ### Economics of LSAs The starting point of any transfer pricing analysis involving LSAs should be their identification. The perception that LSAs are available to an MNC can often be unfounded, particularly because an MNC's decision to locate its manufacturing or service operations in India and/or China may be driven more by competitive pressure from the markets that require them to lower costs simply to remain in business than by the prospect of benefiting from LSAs. Clearly, in such instances, location savings are passed on to the companies' end customers, and does not warrant any further change to the prevailing transfer pricing arrangements. It is only in certain instances that LSAs give rise to location rents that are actually retained within an MNC. Assuming that LSAs give rise to location rents, the process of quantifying the rent should take into account the net benefit to the MNC by recognizing benefits that can be inherent to operations in a developing country. Benefits may manifest themselves through low input costs, specialized skilled manpower, government subsidies, scale economies, and lower environmental standards. On the end-product market side, benefits may take the form of higher demand for branded products resulting in price premiums, entry barriers limiting competition, or unique features of the consumers in a market that make it easier for companies to sell products into those markets. These benefits may be offset by economic costs such as higher transportation costs, higher warranty costs, higher cost of capital, economic costs of managing an operation in a remote location, and higher indirect costs of doing business. The quantification of location rents should be based on a careful consideration of both advantages and disadvantages of operating in these markets. Incidentally, both India and China have acknowledged the presence of dissavings when quantifying LSAs. Once the location rent is quantified, the next step in the analysis is to allocate this rent to the parties involved in generating such rents. Relative bargaining power is recognized as the key factor for that allocation. In the absence of third-party comparables that provide guidance on how such bargaining powers are manifested in market transactions, concepts of bargaining theory in economics provide useful guidance to determine how third parties would split such profits. Several important factors affect the outcome of a bargaining situation: 1. **Time value of money:** one party's bargaining power is greater the more patient it is, relative to the other negotiator. All other things remaining constant, if all the entities on the bargaining table value the cost of waiting in the same manner (that is, the present value of the future is discounted at the same rate for all parties), the outcome will likely be one where each entity will split the location rent equally. 2. **Risk of breakdown:** While bargaining, the parties may perceive that the negotiations might break down into disagreement because of some exogenous and uncontrollable factors. For example, while two firms bargain over how to divide the returns from a new technology, an outside firm may discover a superior technology that makes their technology obsolete. The exact partition of the net surplus between the entities will depend on their relative degrees of impatience (as described above) and on their relative degrees of aversion to risk. 3. **Outside options:** A key principle is that an entity's outside option will increase its bargaining power if and only if the outside option is sufficiently attractive; if it is not attractive enough, then it will have no effect on the bargaining outcome. This is the so-called outside option principle (OOPS). 4. **Role of commitment: **In many bargaining situations, the parties often take actions before and/or during the negotiation process that partially commit them to some strategically chosen bargaining positions (or "demands"). Those commitments are partial in that they are revocable, but revoking a partial commitment (backing down from one's demands) can be costly. The presence of such commitments (such as a long-term supply contract with another member of the MNC) can have an impact on how location rents are split. 5. **Asymmetric information: **There may be instances in which one entity has access to relevant information important to the business that the other does not; such informational asymmetries will also have an impact on the bargaining outcome. Often, it is difficult to argue that the location savings should accrue to the MNC entity located in the low-cost country because the intangible-owning entrepreneur entity often has more options than the entity located in the low-cost country, thus reducing its bargaining power to retain any location savings that might exist. **India's position on LSAs** Over the last few years, the Indian tax authorities have been stressing that a portion of any LSAs should accrue to the Indian entity and be subject to tax in India. However, they have yet to announce or apply a systematic approach for identifying and quantifying LSAs. The Indian tax authorities' aggressive view on this topic is clear from their submission to the UN Transfer Pricing Manual. India's submission begins by asserting that India not only provides location savings but other LSAs such as access to highly specialized skilled manpower and knowledge; access and proximity to a growing local/regional market; a large customer base with increased spending capacity; a superior information network; a superior distribution network; incentives; and market premiums. The Indian chapter of the manual goes on to state, without much basis: "The Indian transfer pricing administration believes it is possible to use the profit split method to determine arm's-length allocation of location savings and rents in cases where comparable uncontrolled transactions are not available." This is a fairly aggressive stance, without much regard to how such an approach may be applied. India's submission also states that transfer prices defended using local comparable companies do not capture the benefit of location savings. India's tax department has already lost on this last position in the Income Tax Appellate Tribunal, the first judicial level at which income tax cases are argued in India. The desire to include location savings in Indian profits has been raised multiple times by Indian government representatives in seminars, forums, tax assessments, and APA discussions. However, the authors have not come across any instance where the Indian government has been successful in quantifying the location savings and arguing that they should accrue to the Indian entity. **China's position on LSAs** China's State Administration of Taxation (SAT) first officially expressed its views on location savings in Guo Shui Han \[2009\] No. 106, and on market premiums in Guo Shui Han \[2010\] No. 84. In the SAT's view, many foreign corporations should have higher profit margins due to location savings and/or market premiums because of the lower cost and higher selling prices found in China. In recent years, the SAT has paid special attention to the automotive, pharmaceutical, and luxury industries because of the importance of LSAs in those industries. The SAT has recently used LSAs (and other arguments) in transfer pricing audits. For instance, a foreign company's Chinese subsidiary was determined to adjust its income tax for more than RMB100 million for 10 years. LSAs also have been used in self-adjustments, which are similar to transfer pricing audits although not legally official and conducted by state tax bureaus. The SAT has also used LSAs in bilateral APA cases, especially in negotiations with Japan's National Tax Authority. Chinese courts have adjudicated very few transfer pricing cases, and none of them involve LSAs. In the SAT's view, Chinese companies should get most, if not all, of LSAs. But up to this point, the SAT has not come up with an acceptable approach to allocate LSAs benefits. **Suggestions and anticipated future development** According to the OECD transfer pricing guidelines, location savings should be allocated based on relative bargaining powers, but the guidelines are vague on the allocation of benefits. Even though the OECD guidelines do not mention market premiums, it is an important issue -- at least in China -- and should be taken into account as well. The important issue is how to estimate and allocate LSAs. The calculation of LSAs may not be too difficult, as long as all location dissavings and factors such as custom duties are taken into account. Also, indirect approaches, especially for location savings, must be used because of the difficulties in using direct approaches and the need to repeat the procedure every year. The difficulty, rather, is how to appropriately allocate relevant savings/premiums. There are several approaches for allocating location savings. One of them is using domestic or regional comparable companies. But in some countries, such as China, there are few domestic public companies. Another potential issue is that in the tax authorities' view, selected comparable companies are not comparable enough based on functions, risks, and products. But one thing for sure is that location savings cannot be estimated based on cost savings only, because some savings are passed on to customers. It is comparatively easier to estimate and allocate market premiums. As long as taxpayers take the difference in selling prices in China/India and developed countries, and other relevant factors (such as custom duties) into account, the market premium can be reasonably estimated. The difficulty here is still about comparable companies, especially in China, because there are very few publicly traded distributors. For manufacturing parts, for the same reason, would it be reasonable to allocate market premium based on two companies' relevant cost, say the Chinese/Indian entity's own manufacturing cost and the foreign entity's value of important parts? The result may not be absolutely accurate, but at least it's reasonable. The key in the near future is to engage with the tax authorities to share with them these positions and come up with reasonable ways to estimate and allocate LSAs. **Eclectic Theory: Advantages and Disadvantages** An **eclectic paradigm**, also known as the ownership, location, internationalization (OLI) model or OLI framework, is a three-tiered evaluation framework that companies can follow when attempting to determine if it is beneficial to pursue foreign direct investment (FDI). This paradigm assumes that institutions will avoid transactions in the open market if the cost of completing the same actions internally, or in-house, carries a lower price. It is based on internalization theory and was first expounded upon in 1979 by the scholar John H. Dunning.  **Understanding** **Eclectic Paradigms** The eclectic paradigm takes a holistic approach to examining entire relationships and interactions of the various components of a business. The paradigm provides a strategy for operation expansion through FDI. The goal is to determine if a particular approach provides greater overall value than other available national or international choices for the production of goods or services. Since businesses seek the most cost-effective options while still maintaining quality, they may use the eclectic paradigm to evaluate any scenario which exhibits potential. **Three Key Factors of the Eclectic Paradigm** For FDI to be beneficial, the following advantages must be evident: The first consideration, ownership advantages include proprietary information and various ownership rights of a company. These may consist of branding, copyright, trademark or patent rights, plus the use and management of internally-available skills. Ownership advantages are typically considered to be intangible. They include that which gives a competitive advantage, such as a reputation for reliability. Location advantage is the second necessary good. Companies must assess whether there is a comparative advantage to performing specific functions within a particular nation. Often fixed in nature, these considerations apply to the availability and costs of resources, when functioning in one location compared to another. Location advantage can refer to natural or created resources, but either way, they are generally immobile, requiring a partnership with a foreign investor in that location to be utilized to full advantage. Finally, internalization advantages signal when it is better for an organization to produce a particular product in-house, versus contracting with a third-party. At times, it may be more cost-effective for an organization to operate from a different market location while they keep doing the work in-house. If the business decides to outsource the production, it may require negotiating partnerships with local producers. However, taking an outsourcing route only makes financial sense if the contracting company can meet the organization's needs and quality standards at a lower cost. Perhaps the foreign company can also offer a greater degree of local market knowledge, or even more skilled employees who can make a better product. **Real World Example** According to Research Methodology, an independent research and analyst firm, the eclectic paradigm was applied by Shanghai Vision Technology Company, in its decision to export its 3D printers and other innovative tech offerings. While their choice strongly considered the disadvantage of higher tariffs and transportation costs, their internationalization strategy ultimately allowed them to flourish in new markets. **[Forms of Protections:]** Tariffs and Non-Tariffs Barriers in International Trade Trade barriers are restrictions imposed on movement of goods between countries. Trade barriers are imposed not only on imports but also on exports. The trade barriers can be broadly divided into two broad groups: (a) Tariff Barriers and (b) Non-tariff Barriers. ### Tariff Barriers Tariff is a customs duty or a tax on products that move across borders. The most important of tariff barriers is the customs duty imposed by the importing country. A tax may also be imposed by the exporting country on its exports. However, governments rarely impose tariff on exports, because, countries want to sell as much as possible to other countries. The main important tariff barriers are as follows: **(1) Specific Duty: **Specific duty is based on the physical characteristics of goods. When a fixed sum of money, keeping in view the weight or measurement of a commodity, is levied as tariff, it is known as specific duty. For instance, a fixed sum of import duty may be levied on the import of every barrel of oil, irrespective of quality and value. It discourages cheap imports. Specific duties are easy to administer as they do not involve the problem of determining the value of imported goods. However, a specific duty cannot be levied on certain articles like works of art. For instance, a painting cannot be taxed on the basis of its weight and size. **(2)** **Ad Valorem Duty: **These duties are imposed "according to value." When a fixed percent of value of a commodity is added as a tariff it is known as ad valorem duty. It ignores the consideration of weight, size or volume of commodity. The imposition of ad valorem duty is more justified in case of those goods whose values cannot be determined on the basis of their physical and chemical characteristics, such as costly works of art, rare manuscripts, etc. In practice, this type of duty is mostly levied on majority of items. **(3)** **Combined or Compound Duty: **It is a combination of the specific duty and ad valorem duty on a single product. For instance, there can be a combined duty when 10% of value (ad valorem) and Re 1/- on every meter of cloth is charged as duty. Thus, in this case, both duties are charged together. **(4) Sliding Scale Duty: **The import duties which vary with the prices of commodities are called sliding scale duties. Historically, these duties are confined to agricultural products, as their prices frequently vary, mostly due to natural factors. These are also called as seasonal duties. **(5) Countervailing Duty: **It is imposed on certain imports where products are subsidized by exporting governments. As a result of government subsidy, imports become cheaper than domestic goods. To nullify the effect of subsidy, this duty is imposed in addition to normal duties. **(6) Revenue Tariff: **A tariff which is designed to provide revenue to the home government is called revenue tariff. Generally, a tariff is imposed with a view of earning revenue by imposing duty on consumer goods, particularly, on luxury goods whose demand from the rich is inelastic. **(7) Anti-dumping Duty: **At times, exporters attempt to capture foreign markets by selling goods at rock-bottom prices, such practice is called dumping. As a result of dumping, domestic industries find it difficult to compete with imported goods. To offset anti-dumping effects, duties are levied in addition to normal duties. **(8) Protective Tariff: **In order to protect domestic industries from stiff competition of imported goods, protective tariff is levied on imports. Normally, a very high duty is imposed, so as to either discourage imports or to make the imports more expensive as that of domestic products. **Note:** Tariffs can be also levied on the basis of international relations. This includes single column duty, double column duty and triple column duty. ### Non-tariff barriers A non tariff barrier is any barrier other than a tariff that raises an obstacle to the free flow of goods in overseas markets. Non-tariff barriers, do not affect the price of the imported goods, but only the quantity of imports. Some of the important non-tariff barriers are as follows: **(1)** **Quota System: **Under this system, a country may fix in advance, the limit of import quantity of a commodity that would be permitted for import from various countries during a given period. The quota system can be divided into the following categories: \(a) Tariff/Customs Quota    (b) Unilateral Quota \(c) Bilateral Quota               (d) Multilateral Quota - **Tariff/Customs Quota: **Certain specified quantity of imports is allowed at duty free or at a reduced rate of import duty. Additional imports beyond the specified quantity are permitted only at increased rate of duty. A tariff quota, therefore, combines the features of a tariff and an import quota. - **Unilateral Quota: **The total import quantity is fixed without prior consultations with the exporting countries. - **Bilateral Quota: **In this case, quotas are fixed after negotiations between the quota fixing importing country and the exporting country. - **Multilateral Quota: **A group of countries can come together and fix quotas for exports as well as imports for each country. **(2) Product Standards: **Most developed countries impose product standards for imported items. If the imported items do not conform to established standards, the imports are not allowed. For instance, the pharmaceutical products must conform to pharmacopoeia standards. **(3) Domestic Content Requirements: **Governments impose domestic content requirements to boost domestic production. For instance, in the US bailout package (to bailout General Motors and other organizations), the US Govt. introduced 'Buy American Clause' which means the US firms that receive bailout package must purchase domestic content rather than import from elsewhere. **(4) Product Labeling: **Certain nations insist on specific labeling of the products. For instance, the European Union insists on product labeling in major languages spoken in EU. Such formalities create problems for exporters. **(5) Packaging Requirements: **Certain nations insist on particular type of packaging materials. For instance, EU insists on recyclable packing materials, otherwise, the imported goods may be rejected. **(6) Consular Formalities: **A number of importing countries demand that the shipping documents should include consular invoice certified by their consulate stationed in the exporting country. **(7) State Trading: **In some countries like India, certain items are imported or exported only through canalizing agencies like MMTC. Individual importers or exporters are not allowed to import or export canalized items directly on their own. **(8) Preferential Arrangements: **Some nations form trading groups for preferential arrangements in respect of trade amongst themselves. Imports from member countries are given preferences, whereas, those from other countries are subject to various tariffs and other regulations. **(9) Foreign Exchange Regulations: **The importer has to ensure that adequate foreign exchange is available for import of goods by obtaining a clearance from exchange control authorities prior to the concluding of contract with the supplier. **(10) Other Non-Tariff Barriers: **There are a number of other non -- tariff barriers such as health and safety regulations, technical formalities, environmental regulations, embargoes, etc. **Subsidies** Incentives and subsidies are a motivational factor which induces a person to work hard or to do his work more efficiently. Many incentives and subsidies are provided both by the Central and State Governments to promote the growth of small-scale industries and also to protect them from the onslaught of the large-scale sector. Among the various incentives and subsidies given to small-scale industries the following deserve special mention: 1. **Reservation** To protect the small-scale industries from the competition posed by large-scale industries, the Government has reserved the production of certain items exclusively for the small-scale sector. 2. **Preference in Government purchases** The Govern­ment as well as government organizations show preference in procuring their requirements from the small-scale sector. For instance, the Director General of Supplies and Disposals purchases 400 items exclusively from the small-scale sector. The National Small-Scale Industries Corporation assists the SSI units in obtaining a greater share of Government and defence purchases. 3. **Price preference** The SSI units are given price preference up to a maximum of 15 per cent in respect of certain items purchased both from small-scale and large-scale units. 4. **Supply of raw materials** In order to ensure regular supply of raw materials, imported components and equipments, the Government gives priority allocation to the small-scale sector as compared to the large-scale sector. Further, the Government has liberalized the import policy and streamlined the distribution of scarce raw materials. 5. **Excise duty** In respect of SSI units excise duty concessions are granted to both registered and unregistered units on a graded scale depending upon their production value. Full exemption is granted up to a production value of Rs.30 lakhs in a year and 75 % of normal duty is levied for production value exceeding Rs.30 lakhs but not exceeding Rs.75 lakhs. If the production value exceeds Rs.75 lakhs, normal rate of duty will be levied. 6. **RBI's credit guarantee scheme** In 1960, the RBI introduced a Credit Guarantee Scheme for small-scale industries. As per the Scheme, the RBI takes upon itself the role of a guarantee organization for the advances which are left unpaid, including interest overdue and recoverable charges. This scheme covers not only working capital but also advances provided for the creation of fixed capital. 7. **Financial assistance** Small-scale industries are brought under the priority sector. As a result, financial assistance is provided to SSI units at concessional terms by commercial banks and other financial institutions. With a view to providing more financial assistance to the small-scale sector, several schemes have been introduced in the recent past the Small Industries Development Fund (SIDF) in 1986, National Equity Fund (NEF) in 1987 and the Single Window Scheme (SWS) in 1988. SIDF provides refinance assistance to small-scale and cottage and village industries and the tiny sector in rural areas. NEF provides equity type support to small entrepreneurs for setting up new projects in the tiny/small-scale sector. In 1996, the small-scale sector received 42.3 per cent of the total priority sector advances from public sector banks. 8. **Technical consultancy services** The Small Industries Development Organization, through its network of service and branch institutes, provides technical consultancy services to SSI units. In order to provide the necessary technical input to rural industries, a Council for Advancement of Rural Technology was set up in October, 1982. The Technical Consultancy organization renders consultancy services to SSI units at a subsidised rate. Many financial institutions are also providing subsidies to SSI units for availing of consultancy serv­ices. For instance, small entrepreneurs proposing to set up rural, cottage, tiny or small-scale units, can get consultancy services at a low cost from the Technical Consultancy Organizations approved by the All-India and State-level financial institutions. They have to pay only 20% of the fees charged by a technical consultancy organization. The entire balance of 80% or Rs.5, 000 whichever is lower is subsidised by the Industrial Finance Corporation of India. 9. **Machinery on hire purchase basis** The National Small Industries Corporation (NSIC) arranges supply of machinery on hire purchase basis to SSI units, including ancillaries located in backward areas which qualify for investment subsidy. The rate of interest charged in respect of technically qualified persons and entrepreneurs coming from backward areas are less than the amount charged to others. The earnest money payable by technically qualified persons and entrepreneurs from backward areas is 10% as against 15% in other cases. 10. **Transport subsidy** The Transport Subsidy Scheme, 1971 envisages grant of a transport subsidy to small-scale units in selected areas to the extent of 75 % of the transport cost of raw materials which are brought into and finished goods which are taken out of the selected areas. 11. **Training facilities** The Entrepreneurship Development Institute of India, financial institutions, commercial banks, technical consultancy organizations, and NSIC provide training to existing and potential entrepreneurs. 12. **Marketing assistance** The National Small Industries Corporation (NSIC), the Small Industries Development organization (SIDO) and the various Export Promotion Councils help SSI units in marketing their products in the domestic as well as foreign markets. The SIDO conducts training programmes on export marketing and organises meetings and seminars on export promotion. 13. **District Industries Centres (DICs)** The 1977 Industrial Policy Statement introduced the concept of DICs. Accordingly a DIC is set up in each district. The DIC provides and arranges a package of assistance and facilities for credit guidance, supply of raw materials, marketing etc. **Import Duties** Tariffs are essentially taxes or duties placed on an imported good or service by a domestic government, making domestic goods cheaper for domestic consumers and imported goods more expensive for companies exporting goods from their industry into the domestic industry. A domestic government normally levies tariffs as a percentage of the declared value of the good or service and act similar to a sales tax. Unlike sales tax, however, tariff rates often vary depending on the good or service and do not apply to domestic goods, only imports coming into the domestic industry. When a domestic government levies high tariffs, it reduces the imports of a given product or service because the high tariff leads to a higher price for the domestic consumer and a higher import cost for foreign suppliers or producers. Tariffs are also used to create favourable trading conditions between certain countries while hampering the trading conditions of other countries. There are two general types of tariffs levied by domestic governments: ad valorem tax and a specific tariff. Ad valorem tax is a percentage of the value of the good or service, while a specific tariff is a tax based on a set fee per number of items or weight of the items. Tariffs are usually levied by domestic governments to protect new industries against foreign competition, to protect aging industries against foreign competition, to protect against foreign companies offering their products for a price lower than their costs and to raise revenue. Customs Duty is levied when goods are transported across borders between countries. It is the tax that governments impose on export and import of goods. Taxable event is import into or export from India. Import of goods means bring goods from a place outside India. India includes the territorial waters of India which extend up to 12 nautical miles into the sea to the coast of India. In India, the basic law for levy and collection of customs duty is Customs Act, 1962. It provides for levy and collection of duty on imports and exports, import/export procedures, prohibitions on importation and exportation of goods, penalties, offences, etc. The Constitutional provisions have given to Union the right to legislate and collect duties on imports and exports. The Central Board of Excise & Customs (CBEC) is the apex body for customs matters. Central Board of Excise and Customs (CBEC) is a part of the Department of Revenue under the Ministry of Finance, Government of India. It deals with the task of formulation of policy concerning levy and collection of customs duties, prevention of smuggling and evasion of duties and all administrative matters relating to customs formations. The Board discharges the various tasks assigned to it, with the help of its field organizations namely the Customs, Customs (preventive) and Central Excise zones, Commissionerate of Customs, Customs (preventive), Central Revenues Control Laboratory and Directorates. It also ensures that taxes on foreign and inland travel are administered as per law and the collection agencies deposit the taxes collected to the public exchequer promptly. Many development policy analysts and industry-specific advocates argue it's sometimes necessary to implement import tariffs to protect infant domestic industries from foreign competitors. This argument has existed for centuries: Adam Smith, for example, directly advocated for it in the Wealth of Nations, but in practice, infant industry techniques have a poor track record. There are many possible explanations for this, some economic and some political. The infant industry argument does not extend to all types of producers. Industries requiring high economic capital have the most apparent need for state protection from foreign competition. This is because manufacturing and technological production are important to building long-term economic growth, yet establishing these types of firms is both risky and time-consuming. Even though it likely results in forcing local consumers to pay a higher price for domestic goods, proponents of this theory suggest that future gains outweigh the initial disadvantages. However, potential success stories are few and far between. Economists disagree about the importance of tariffs in developing markets in the United States, Germany, and Japan during their respective industrialization periods. Similar tariffs have been tried for key industries in India, Malaysia, Indonesia, Singapore, and Hong Kong with very poor results. One common criticism is that protectionism only works if the domestic firms are well-run and if other government laws allow for sustained growth. Companies still require access to capital and competitive tax rates. Additionally, other countries may respond by instituting their sanctions. Others have theorized that development only occurs where there are gains from trade and that tariffs distort trade, investment, and consumption too much for those gains to be realized. **Voluntary Export Restraints, Administrative Policy, Anti-dumping Policy** A **voluntary export restraint (VER)** is a trade restriction on the quantity of a good that an exporting country is allowed to export to another country. This limit is self-imposed by the exporting country. Voluntary export restraints (VERs) fall under the broad category of non-tariff barriers, which are restrictive trade barriers, like quotas, embargoes, sanctions levies, and other restrictions. Typically, VERs are a result of requests made by the importing country to provide a measure of protection for its domestic businesses that produce competing goods, though these agreements can be reached at the industry level, as well. - A voluntary export restraint (VER) is a self-imposed limit on the quantity of a good that an exporting country is allowed to export. - VERs are considered non-tariff barriers, which are restrictive trade barriers---such as quotas and embargoes. - Related to a voluntary import expansion, which is meant to allow for more imports, and can include lowering tariffs or dropping quotas. **Administrative Policy** Countries are sometimes accused of using their various administrative rules (e.g. regarding food safety, environmental standards, electrical safety, etc.) as a way to introduce barriers to imports. **Anti-dumping Policy** An anti-dumping duty is a protectionist tariff that a domestic government imposes on foreign imports that it believes are priced below fair market value. Dumping is a process where a company exports a product at a price lower than the price it normally charges in its own home market. For protection, many countries impose stiff duties on products they believe are being dumped in their national market, undercutting local businesses and markets. The World Trade Organization (WTO) operates a set of international trade rules. Part of the organization's mandate is the international regulation of anti-dumping measures. The WTO does not regulate the actions of companies engaged in dumping. Instead, it focuses on how governments can---or cannot---react to dumping. In general, the WTO agreement allows governments to "act against dumping where there is genuine (material) injury to the competing domestic industry." In other cases, the WTO intervenes to prevent anti-dumping measures.