Module 5 (International Trade)

Advantages and disadvantages of international trade - Absolute and Comparative advantage

theory - Heckscher-Ohlin theory - Balance of payments – Components – Balance of
Payments deficit and devaluation – Trade policy – Free trade versus protection – Tariff and
non-tariff barriers.

5.1 International trade

International trade refers to the exchange of capital, goods and services across
international borders. Without trade, nations would have to rely only on products produced
domestically. Trade plays a dominant role in the economic development of a country by
helping it widen its market.

Advantages of International Trade

1. International trade enables countries to specialize in the production of those

commodities in which they have a comparative advantage.
2. It increases the size of a firm’s market, resulting in lower average costs and higher
productivity.
3. International competition promotes innovative production, new technology and
marketing.
4. Consumers benefit in the domestic economy as they can now obtain a greater variety
of goods and services.
5. The increased competition ensures commodities are supplied at the lowest prices.
6. It results in foreign exchange gains. When India sells its products abroad, it receives
foreign currency. This money is then used to pay for imports that are produced more
cheaply overseas.
7. Free trade creates new jobs in the domestic economy. Employment will increase in
exporting industries.
8. The countries involved in free trade experience rising living standards, increased real
incomes and higher rates of economic growth. This is created by more competitive
industries, increased productivity, efficiency and production levels
9. Greater access to imports will benefit consumers and businesses by widening the
choice of products available and boosting the living standards of the people.
10. Having a bigger market to sell to means that a business can sell more, earn more
profits and pay higher wages. Exporting businesses pay more to workers and sell
more per worker than non-exporters.
11. In the absence of trade, governments may distort market prices by subsidizing
production. In such cases, production and trade, guided by distorted prices, will not be
efficient.
12. One clear cost of protection is that the country imposing it forces its consumers to
forgo cheap imports.

Module 5 1
Disadvantages of International Trade

1. The main argument for protectionism is the infant industry argument. Industries in
developing countries can effectively compete with those already developed if they
receive some initial protection in the form of tariffs or subsidies.
2. Increased economic stability as economies do not become dependent on global
markets. This means that businesses are not vulnerable to downturns in the
economies of their trading partners, e.g. Recession in the USA leads to decreased
demand for India’s exports, leading to falling export incomes, lower GDP, lower
incomes, lower domestic demand, and rising unemployment.
3. Countries with surplus products may dump them on world markets at prices below
the cost of production.
4. Countries whose economies are largely agricultural face unfavourable terms of
trade. Their export income is much smaller than the import payments they make for
high value imports resulting in large foreign debt levels.
5. All round industrial development will occur in the country since it cannot depend on
foreign industries.
6. Free trade can lead to pollution and other environmental problems as companies fail
to include these costs in the price of goods while trying to compete with companies
operating under weaker environmental legislation in some countries.
7. If old traditional industries are not protected, foreign competition may ruin them and
create unemployment.
8. It is unwise to export all the natural resources of a country. For example, India has
exhausted its large supply of manganese and mica in the name of earning foreign
exchange.
9. Protective import duties are a way to generate tax revenue.
10. During times of global financial crises and recession, falling employment has often
resulted in an increase in protectionist policies in many countries. Governments in
the United States, Britain and other European countries have faced domestic
pressure to stop purchases from Chinese and Indian companies.

5.2 Absolute advantage theory of international trade

Assumptions
1. There are no barriers to trade in goods.
2. Labour is the only relevant factor of production.
3. Production exhibits constant returns to scale.
4. There are no transportation costs.
5. Labour is mobile within a country but immobile between countries.

The Theory
The theory of absolute advantage was put forward by Adam Smith. The theory states
that the basis of international trade is absolute advantage in the production of a commodity. It
Module 5 2
was the trade theory that first indicated the importance of specialization and division of
labour.
Suppose there are two commodities and two countries which produce these
commodities. One country is efficient in the production of one commodity and has an
absolute advantage in the production of this commodity. The other country has an absolute
advantage in the production of the other commodity. The countries will specialise in the
commodity in which they have an absolute advantage. They will export this commodity to
the other country. From this trade both the countries will benefit.
The following table gives the man-hours required to produce a unit of wheat and
cloth in the US and UK.

Labour cost in hours required to produce one unit of wheat or cloth

U.S. U.K.
Wheat 3 10
Cloth 6 4

It will be seen from the above table that to produce one unit of wheat in the U.S. 3
hours of labour and in U.K. 10 hours are required. To produce one unit of cloth, in the U.S. 6
hours of labour and in U.K. 4 hours are required. Thus the U.S. can produce wheat more
efficiently (that is, at a lower cost), while U.K. can produce cloth more efficiently.
U.S. has an absolute advantage in the production of wheat while U.K. has an absolute
advantage in the production of cloth. Adam Smith showed that the two countries would
benefit and world output will increase if the two countries specialize in the production of
goods in which they have absolute advantage and trade with each other.
How such specialization and trade would lead to gain in output and would be
mutually beneficial for the two countries is shown in the following table.

Gain in Output when labour is transferred

U.S. U.K. World Output
Gain in wheat +2 -1 +1
Gain in cloth -1 +2.5 +1.5

Suppose to specialize in the production of wheat, the U.S. withdraws 6 man-hours

from the production of cloth and devote them to the production of wheat, it will lose 1 unit of
cloth and gain 2 units of wheat.
Similarly, to specialize in the production of cloth if U.K. withdraws 10 hours of
labour from wheat and use them for the production of cloth, it will lose one unit of wheat but
gain 2.5 units of cloth.
The total world output of wheat would increase by 1 unit while that of cloth would
increase by 1.5 units. According to Adam Smith, international division of labour and trade
leads to the expansion in world output and wealth without any increase in productive
resources.

Criticism

Module 5 3
 1. The theory assumed that each exporting country has an absolute advantage in the
production of a commodity. Developing countries may not have any such advantage.
2. There are a large number of factors influencing trade between countries.
3. The theory does not consider that countries are often forced to export to neutralise
their balance of payments deficit.

5.3 Comparative advantage theory of international trade

The theory of comparative advantage was put forward by David Ricardo. The theory
states that the basis of international trade is comparative advantage in the production of a
commodity. He argued that even if the countries did not have an absolute advantage in the
production of any product, international trade would be beneficial and would bring gains to
all countries.
A country will specialise in that line of production in which it has a greater
comparative advantage in costs than other countries and will import those in which it has a
comparative cost disadvantage. Each country will benefit if it specializes in the production
and export of those goods that it can produce at relatively lower cost.
Assumptions
1. Labour is the only relevant factor of production.
2. Production exhibits constant returns to scale.
3. There are no transportation costs.
4. Labour is mobile within a country but immobile between countries.
5. There is no intervention by government in the economic system.
6. Perfect competition exists both in the commodity and factor markets.
7. There is full employment of resources in both the countries.

This two-country, two-commodity model can be analysed through the Table 2.3

Country Labour cost per unit of Exchange ratio

commodity in hours
Cloth Wheat Domestic exchange Domestic exchange
ratio of Cloth ratio of Wheat
England 12 10 1 unit of cloth = 12/10 1 unit of wheat =
or 1.20 units of wheat 10/12 or 0.83 units of
cloth
Portugal 16 12 1 unit of cloth = 16/12 1 unit of wheat =
or 1.33 units of wheat 12/16 or 0.75 unit of
cloth

The above table indicates that England has an absolute advantage in producing both
the commodities through smaller inputs of labour than Portugal. It does not mean that
England will specialise in both cloth and wheat and Portugal will have nothing to export. In
England, domestic exchange ratio between cloth and wheat is 12:10, i.e., 1 unit of cloth =
12/10 or 1.20 units of wheat. Alternatively, 1 unit of wheat = 10/12 or 0.83 units of cloth. In
Module 5 4
Portugal, the domestic exchange ratio is 16:12, i.e., 1 unit of cloth = 16/12 or 1.33 units of
wheat. Alternatively, 1 unit of wheat = 16/12 or 0.75 unit of cloth.
From the above cost ratios, it follows that England has comparative cost advantage in
the production of cloth and Portugal has comparatively lesser cost disadvantage in the
production of wheat. . Accordingly, England will specialise in the production and export of
cloth, while Portugal will specialise in the production and export of wheat.

Diagrammatic representation of the gains from trade

In the following figure, AA1 and BB1 are the production possibility curves pertaining
to England and Portugal. Using the same amount of productive resources, England can
produce larger quantities of both the commodities than Portugal and hence England has
absolute cost advantage over Portugal in respect of both the commodities.
If the curve BC1 is drawn parallel to AA1, the curve BC1 can represent the production
possibility curve of England. If England gives up OB quantity of wheat and diverts resources
to the production of cloth, it can produce OC1 quantity of cloth, which is more than OB1. It
means that England has comparative cost advantage in the production of cloth.
From the point of view of Portugal, it can produce the same quantity OB of wheat, if
it gives up the production of smaller quantity OB1 of cloth. If signifies that Portugal has less
comparative disadvantage in the production of wheat. Accordingly, England will specialise in
the production and export of cloth, while Portugal will specialise in the production and export
of wheat.

Criticism
1. The theory assumes that there are no other costs except labour costs.
2. The theory assumes constant returns to scale. Diminishing returns are likely to set in
as scale increases.
3. The theory ignores differences in transport cost.
4. The assumption that labour is mobile only within the country is not valid.
5. The theory assumes the existence of perfect competition.

Module 5 5
 6. Actual international trade is influenced by various government restrictions like tariffs
and other trade restrictions.
7. The assumption of full employment is not valid.

5.4 Heckscher - Ohlin theory of international trade (Factor endowment

theory)
The Heckscher-Ohlin theorem was developed by Eli Heckscher and Bertil Ohlin. The
theory states that the capital abundant country will export capital intensive goods and import
labour intensive goods and the labour abundant country will export labour intensive goods
and import capital intensive goods.
Ohlin pointed out that differences in factor endowments of nations and difference in
factor proportions of producing different commodities form the ultimate basis of international
trade.
Assumptions
1. There are only two factors of production.
2. It is a two country two commodity model.
3. There is perfect competition.
4. There is full employment.
5. There are no transport costs.
In the figure, the production possibility curve of country A is AB that of country B is
CD. Steel is the capital intensive good and cloth is the labour intensive good.

Suppose, the two countries produced the goods in the same proportion along the ray
OR. Country A would produce at Q1 and country B at Q2 on their respective production
possibility curves. The slope of country A’s production-possibility curve at Q1, is steeper than
the corresponding slope of country B at Q2. This implies that steel is cheaper in country A
and cloth is cheaper in country B, if the two countries are producing at Q1 and Q2
respectively. Country A would, therefore, tend to expand production of steel and country B
would do so for cloth. This means that country A, a capital abundant country, has a

Module 5 6
production bias in favour of the capital-intensive good, steel, while the labour-abundant
country, country B, has a bias in favour of producing the labour intensive good, cloth.

Merits
1. The H-O theory takes into account both the demand and supply factors for
determining international trade.
2. This model lays down a permanent basis for international trade.
3. The theory maintains that production involves two factors of production-labour and
capital.
4. The theory is based upon the general theory of value.
5. This theory explains the reason for comparative cost differences between nations in
terms of factor endowments.
Criticism
1. It is a two commodity model.
2. The theory assumes perfect competition.
3. The theory assumes that there is full employment.
4. The theory ignores differences in transport cost.
5. The theory ignores technological changes.

5.5 Balance of payments

Balance of payments (BOP) sheet is an accounting record of all monetary transactions
between a country and the rest of the world. These transactions include payments for the
country's exports and imports of goods, services, financial capital and financial transfers. The
BOP summarizes the international transactions for a specific period, usually a year. Sources
of funds for a nation, such as exports or the receipts of loans and investments, are recorded as
positive or surplus items. Uses of funds, such as for imports or investment in foreign
countries are recorded as negative or deficit items.
Importance of balance of payments
1. The BOP statement of a country is an indicator of its economic status in the world.
2. It helps the government formulate its trade policies.

Components of BOP
The BOP is divided into three main components or elements: the current account, the
capital account, and the financial account.

1. The Current Account

Module 5 7
 It is used to monitor the inflow and outflow of goods and services in a country. It is
called current since it refers to transactions currently occurring - those that do not give rise to
future claims. The trade position of the country is reflected by the current account. A current
account is in balance when the country has enough resources to fund all of its foreign
purchases. India has a current account deficit.
The current account consists of:
a. Merchandise trade. This is referred to as visible trade. This is the trade in manufactured
goods and raw materials.
b. Services. This is referred to as invisible trade. It is the sale of services like travel and
tourism, insurance, engineering, patents and copyrights etc.
c. Income receipts. This includes income derived from ownership of assets abroad such as
dividends from shares and interest from bonds.
d. Unilateral transfers. These include worker remittances from abroad, foreign aid,
contribution to charitable institutions and gifts from one country to another.
When combined, goods and services together make up a country's balance of
trade (BOT). The BOT forms the biggest bulk of a country's balance of payments as it makes
up total imports and exports. If a country has a balance of trade deficit, it imports more than it
exports, and if it has a balance of trade surplus, it exports more than it imports.

2. The Capital Account

The capital account refers to the net change in ownership of foreign assets. It is where
all international capital transfers are recorded. This refers to the acquisition or disposal of
international assets. If a country purchases more foreign assets than it sells then the capital
account is said to be in deficit.
The capital account is divided into:
a. Capital transfers.
b. Purchase and sale of real assets.

3. The Financial Account

In the financial account, international monetary flows related to investment in
business, real estate, bonds, and stocks are documented. Also included are
government-owned assets such as foreign reserves, gold, special drawing rights held with
the International Monetary Fund, private assets held abroad, and direct foreign investment.
Assets owned by foreigners are also recorded in the financial account.
Apart from the above three major components, bop also includes:
4. Official reserve account.
It refers to the foreign currency held by the central bank of a country and is used to
balance the payments from year to year.

5. Errors and Omissions

Sometimes the balance of payments does not balance. It is due to errors that have
crept in during the compilation of the bop statement. Hence an entry called errors and
omissions is made to reflect this imperfection.

Module 5 8
5.6 Balance of Payments deficit
The international BOP of a country reflects its economic strengths and weaknesses.
Surpluses or deficits in the bop can lead to imbalances between countries. In general there is
concern over deficits in the current account. Countries with deficits in their current accounts
will build up increasing debt or see increasing foreign ownership of their assets.

Reasons for disequilibrium in balance of payments

1. Economic Factors
a) The BOP will have deficits if the level of imports in a country is high.
b) Lack of adequate international capital inflow into a country.
c) External borrowings and loans from foreign countries.
d) Rising petroleum prices have put a strain on the forex reserves of several countries.
e) The quality of products of developing countries are not up to the world standards due
to which they could not sustain foreign markets.

2. Political Factors
a) Political instability in a country creates uncertainty among foreign investors
which leads to a reduced inflow of foreign capital into the country.
b) Disequilibrium in BOP also occurs in the event of fear of war with some other
country.
3. Structural Factors
a) The high degree of protection given to domestic industries leads to inefficiency and
poor quality products. Hence exports suffer.
b) In the case of India, the instability in the exchange value of the rupee was another
problem. This has created problems for both exporters and importers. Even though the
value of rupee was managed by the central bank, it was not able to maintain stability
since the currency was often affected by factors beyond the control of the RBI.
4. Social Factors
a) Countries like India export mainly agriculture and agro based products. The price of
these have fluctuated heavily in the world markets.
b) Indian agricultural exports were constantly affected by crop failures.
5. Technological Factors
a) The lack of thrust in research and development has created a situation where countries
like India have very few products that foreigners find attractive.
b) Excessive stress on technology intensive export-oriented industries by countries like
China has resulted in bop disequilibrium in countries like India.

5.7 Methods to correct disequilibrium in the BOP

1. Monetary Measures
a) Monetary Policy. Monetary policy is the policy concerned with the supply of money
in the economy. A reduction in the money supply will decrease the purchasing power

Module 5 9
 of the people. Demand will decline and prices will come down. This reduces imports
and encourages exports.
b) Devaluation. It is the lowering of the exchange value of the currency of a country.
When a country devalues its currency, exports becomes cheaper and imports become
expensive which causes a reduction in the BOP deficit.
c) Exchange Control. In exchange control, all exporters are directed by the monetary
authority to surrender their foreign exchange earnings, and the total available foreign
exchange is rationed among the licensed importers.

2. Trade policy measures

a) Export Promotion. The country tries to increase exports by adopting various measures
like reducing export duties, providing incentives to exporters, providing subsidies to
exporters and exempting exports from taxes.
b) Import Substitution. Steps may be taken to encourage the production of goods which
are currently being imported. This will save valuable foreign exchange.
c) Import Control. Imports and foreign travel is strictly monitored since they take away
valuable foreign exchange. All foreign exchange earned has to be surrendered to RBI
which then rations it out.

3. Non- Monetary measures

a) Promoting international travel and tourism.
b) Inviting foreign companies to come and invest in the country.
c) Taking extra efforts to ensure that Indians working abroad deposit their savings in
banks in India.
d) Postponing debt repayments.
e) Keeping inflation under control.
f) Check on smuggling

5.8 Devaluation
It is the lowering of the exchange value of the currency of a country. When a country
devalues its currency, exports becomes cheaper and imports become expensive which causes
a reduction in the BOP deficit.
As a result of reduction in the exchange rate of a currency with respect to foreign
currencies, the prices of goods to be exported fall, whereas prices of imports go up. This
encourages exports and discourages imports. With exports so stimulated and imports
discouraged, the deficit in the balance of payments will tend to be reduced.

Objectives of Devaluation
1. To boost exports. Imports become more expensive and exports become more
competitive and lucrative.
2. To encourage a greater quantity of export from the country whose currency is being
devalued.

Module 5 10
 3. To reduce trade deficits. The increase in exports along with a reduction in imports will
cause a positive impact on the balance of trade.
4. To lower the cost of a country’s external debt.

Condition for devaluation

Devaluation will be effective only if the demand for exports is elastic. The value of
price elasticity should be greater than 1. In the following figure, the demand curve is elastic.
Even a small percentage change in the price of exports will result in a large percentage
change in quantity. The loss in revenue due to a decline in price is more than compensated by
the gain in revenue due to the increase in quantity purchased. Hence devaluation is
recommended.

In the figure given below, the demand curve is inelastic. A large percentage change in the
price of exports will result in a small percentage change in quantity. The loss in revenue due
to a decline in price is more than the gain in revenue due to the increase in quantity
purchased.

Module 5 11
Limitations of devaluation
1. Devaluation may cause inflation. Higher exports due to the devaluation in the
currency will increase the level of income of the consumers causing domestic demand
to rise, which raises prices.
2. It can result in an increase in the production cost of commodities that depend on
inputs that are imported.
3. Domestic companies that have taken international loans will face greater servicing
costs.
4. It will foster uncertainty within the global markets.
5. Devaluation may also spark trade wars. It will create tension with other competing
countries.

5.9 Free trade versus protection

Free trade
Free trade occurs when there are no artificial barriers put in place by governments to
restrict the flow of goods and services between trading nations. When trade barriers, such as
tariffs and subsidies are put in place, they protect domestic producers from international
competition and redirect, rather than create trade flows.

Free trade is supported as the policy, which is most conducive to maximizing the
economic welfare of a given society. It is argued that free trade allows different economies to
make use of comparative advantages by the exchange of commodities. After the signing of
the General Agreement on Tariffs and Trade, per capita growth was at an all-time high while
tariffs were at a historically low level. People within a national economy will all be better off
if they specialize at what they do best instead of trying to be self-sufficient.

Advantages of free trade

Module 5 12
 1. International trade enables countries to specialize in the production of those
commodities in which they have a comparative advantage.
2. It increases the size of a firm’s market, resulting in lower average costs and higher
productivity.
3. International competition promotes innovative production, new technology and
marketing.
4. Consumers benefit in the domestic economy as they can now obtain a greater variety
of goods and services.
5. The increased competition ensures commodities are supplied at the lowest prices.
6. It results in foreign exchange gains. When India sells its products abroad, it receives
foreign currency. This money is then used to pay for imports that are produced more
cheaply overseas.
7. Free trade creates new jobs in the domestic economy. Employment will increase in
exporting industries.
8. The countries involved in free trade experience rising living standards, increased real
incomes and higher rates of economic growth. This is created by more competitive
industries, increased productivity, efficiency and production levels
9. Greater access to imports will benefit consumers and businesses by widening the
choice of products available and boosting the living standards of the people.
10. Having a bigger market to sell to means that a business can sell more, earn more
profits and pay higher wages. Exporting businesses pay more to workers and sell
more per worker than non-exporters.
11. In the absence of trade, governments may distort market prices by subsidizing
production. In such cases, production and trade, guided by distorted prices, will not be
efficient.
12. One clear cost of protection is that the country imposing it forces its consumers to
forgo cheap imports.

Protectionism

It is the policy of protecting domestic industries by imposing high customs duties on

foreign products. Economic theory does not rule out protectionism as a welfare maximizing
policy option. Whether or not a particular economy warrants protection depends on whether it
will maximize the economic welfare of its populace. Historically, most economies developed
while significant tariffs were in place and high tariffs tended to coincide with relatively high
rates of per capita GDP growth.

Advantages of protectionism

1. The main argument for protectionism is the infant industry argument. Industries in
developing countries can effectively compete with those already developed if they
receive some initial protection in the form of tariffs or subsidies.
2. Increased economic stability as economies do not become dependent on global
markets. This means that businesses are not vulnerable to downturns in the
Module 5 13
 economies of their trading partners, e.g. Recession in the USA leads to decreased
demand for India’s exports, leading to falling export incomes, lower GDP, lower
incomes, lower domestic demand, and rising unemployment.
3. Countries with surplus products may dump them on world markets at prices below
the cost of production.
4. Countries whose economies are largely agricultural face unfavourable terms of
trade. Their export income is much smaller than the import payments they make for
high value imports resulting in large foreign debt levels.
5. All round industrial development will occur in the country since it cannot depend on
foreign industries.
6. Free trade can lead to pollution and other environmental problems as companies fail
to include these costs in the price of goods while trying to compete with companies
operating under weaker environmental legislation in some countries.
7. If old traditional industries are not protected, foreign competition may ruin them and
create unemployment.
8. It is unwise to export all the natural resources of a country. For example, India has
exhausted its large supply of manganese and mica in the name of earning foreign
exchange.
9. Protective import duties are a way to generate tax revenue.
10. During times of global financial crises and recession, falling employment has often
resulted in an increase in protectionist policies in many countries. Governments in
the United States, Britain and other European countries have faced domestic
pressure to stop purchases from Chinese and Indian companies.

5.10 Trade policy

Trade policy refers to the regulations and policies that state how a country carries out
international trade with other foreign countries. It is also referred to as commercial policy. It
consists of tariffs on imported goods, quotas, export constraints and restrictions on the
domestic operations of foreign companies. Subsidies may also be provided to domestic
industries to enable them to compete with foreign industries.
A major component of trade policy are trade barriers consisting of tariffs and
non-tariff barriers.

Tariff
A tariff is a tax imposed by one country on the goods and services imported from
another country. Tariffs are used to restrict imports. They increase the price of goods
purchased from another country, making them less attractive to domestic consumers. They
are used to (a) discourage domestic consumers from consuming foreign goods and (b)
encourage consumption and production of the domestically produced import-replacement
substitutes.

The effect of a tariff is explained with the help of an example from the American
market. The domestic demand curve of American consumers is drawn as DD and the
domestic supply curve of American firms as SS. In a situation where there is no international

Module 5 14
trade, price would be high at $8 per unit and domestic producers would be meeting all the
demand.

The world price of cloth is equal to $4 per unit. If international free trade occurs, the
price in America would equal the world price level. The horizontal line at $4 represents the
supply curve for imports, it is horizontal or perfectly price-elastic because American demand
is assumed to be too small to affect the world price of cloth. Once trade opens up, imports
flow into America lowering the price of clothing to the world price of $4 per unit. Domestic
producers will supply 100 units while at that price consumers will want to buy 300 units. The
difference, shown by the line EF, is the amount of clothing imports.

Suppose America imposes a tariff of $2. The price per unit is now $6. Domestic
consumption is now lowered from 300 units in the free-trade equilibrium to 250 units.
Domestic production is raised by 50 units, and the quantity of imports is lowered by 100
units. A tariff will tend to raise price, lower the amount imported and raise domestic
production of the good.

Types of Tariffs
There are several types of tariffs and barriers that a government can employ:

1. Specific tariffs. It is a fixed amount of tariff imposed on one unit of an imported or

exported good.
2. Ad valorem tariffs. It is levied on a good based on a percentage of that good's value.
3. Countervailing tariffs. These are levied on imported commodities which are heavily
subsidised by foreign governments.
4. Anti-dumping tariffs. These are imposed on imported goods sold in the country at a
price lower than its cost of production.

Advantages of Tariffs
1. Tariffs are a source of revenue for governments.
Module 5 15
 2. Infant industry argument. Industries in developing countries can effectively compete
with those already developed if they receive some initial protection in the form of
tariffs.
3. By making foreign-produced goods more expensive, tariffs can make domestically
produced alternatives seem more attractive.
4. Governments often use tariffs to benefit particular domestic industries.
5. Tariffs are used to protect companies and jobs.
6. Tariffs can also be used as an extension of foreign policy as their imposition on a
trading partner's main exports may be used to exert economic leverage.

Disadvantages of Tariffs
1. They create trade distortions.
2. It can hurt domestic consumers since a lack of competition tends to push up prices.
3. They can make domestic industries less efficient and less innovative by reducing
competition.
4. Tariffs lead to a fall in the volume of international trade.
5. They can generate tensions by favouring certain industries over others.
6. An attempt to pressure a rival country by using tariffs can devolve into an
unproductive cycle of retaliation, commonly known as a trade war.

Non-tariff barriers (NTBs)

A non-tariff barrier is a way to restrict trade using trade barriers in a form other than
a tariff. While tariffs constitute visible barriers to trade, the non-tariff barriers, constitute the
hidden or invisible barriers to trade. In more recent years, these non-tariff barriers have come
into greater prominence than the conventional tariff barriers. These include direct restrictions
or quotas, monetary restrictions, technical and administrative regulations. Their effect on
trade is the same as tariffs - trade restriction and trade distortion causing misallocation of
world resources and reducing global welfare.

Types of Non-Tariff Barriers

There are several types of NTB’s that a government can employ:

1. Quotas. Quantitative restrictions, or quotas, are imposed with a view to reduce the quantity
of imports or exports to a limited size. The effect of quotas are more severe than those which
are created by tariffs since they physically limit the number of a product that a country
imports. Import quotas are more common than export quotas. The world has witnessed severe
import quotas of the mandatory type by the importing countries.
2. Voluntary export restraints. In this case the exporting countries are asked to put voluntary
restraints on their exports.
3. Licenses. Countries may use licenses to limit imported goods to specific businesses. If a
business is granted a trade license, it is permitted to import goods that would otherwise
be restricted for trade in the country.
4. Monetary restrictions. A country can impose foreign exchange controls to limit the volume
of imports. The importer needs foreign exchange to import foreign goods, and the

Module 5 16
government of the country can deny the use of foreign exchange for certain types of imports
or for imports from certain counties. Exchange controls are quite widespread particularly in
the poor countries which experience severe shortage of foreign exchange.
5. Administrative regulations. They include custom restrictions on banning certain products
either on the ground that they constitute a health hazard or they do not meet the safety and
health regulations in the country. For instance, imports of food stuffs or fruits or toys are
restricted on the ground that they constitute a potential health hazard endangering the safety
of people in the country.
6. Technical regulations. They include regulations with regard to labelling and packaging.
7. Customs procedures. Very often, there is administrative delay, lengthy procedures and red
tape in customs clearing aimed at frustrating that the potential importer.
8. Government procurement policies. These policies involve giving preferences to domestic
producers for government procurement.
9. Embargoes. Here countries officially ban the trade of specified goods and services with
another country. Governments may take this measure to support their specific political or
economic goals.
10. Sanctions. Countries impose sanctions on other countries to limit their trade activity.
Sanctions can include increased administrative actions or additional customs and trade
procedures that slow or limit a country’s ability to trade.
11. Local content requirements. The government requires export products to contain a certain
percentage of local raw materials. When increasing local content requirements, the demand
for domestic raw materials increases. That will spur business activities, creating more jobs
and incomes at home.

Advantage of NTBs
1. NTBs support domestic industrial development. It provides sufficient room for
domestic industries to grow, achieve economies of scale, and be competitive in the
international market.
2. NTBs support strategic industrial development. The decline in imports will divert
demand for domestic products.
3. To increase production, domestic companies invest in capital goods and recruit more
local workers. Thus more jobs are created.
4. They create more income and growth in the domestic economy.
5. They are more effective in limiting import volumes. Under quotas, for example, the
main target is the quantity of imports. When the government tries to reduce imports,
quotas are more effective than tariffs because they directly impact import volumes.

Disadvantages of NTBs
1. Governments cannot generate extra income. Under tariff, the government imposes a
tax on imported goods which will increase revenue.
2. They limit the functioning of the free market. Countries should specialize and trade in
products in which they have a comparative advantage. That way, free trade results in
maximum benefits globally.

Module 5 17
 3. The cost of running a business increases. Companies have to fulfil several
administrative requirements such as product standardization.
4. Companies have to follow complicated customs procedures.
5. Exporters face unfair competition in partner countries. Non-tariff barriers are
beneficial for domestic companies but put foreign companies at a disadvantage.
6. Exporters would be able to sell only fewer goods under the quota policy. When
exposed to quota restrictions, they have to find other markets to sell their products. If
not, they have to cut production, lowering their income and profits.
7. When the government limits quotas, the market supply decreases. If domestic
companies cannot compensate by increasing production, then scarcity will occur and
prices will rise.
8. Competitiveness weakens in the long term. Competition is essential for promoting
efficiency, and productivity.
9. Domestic companies have no incentive to spur innovation and introduce new
technology products. The negative effect is a limited selection of goods, low-quality
goods, and high prices.
10. Non-tariff barriers can lead to trade wars. Partner countries can pursue similar policies
to protect their industries resulting in trade retaliation that would upset the balance of
the global economy.

Module 5 18