Block-2

International Trade
BLOCK 2 INTERNATIONAL TRADE
This block deals with the international trade theories and its business implications,
WTO Agreements, the various types of trade blocs, their importance and the major
trade blocs in the world.

This block has following three units.

Unit 4 : Trade Theories

Unit 5 : WTO Agreements

Unit 6 : Regional Trade Blocs
International Trade

70
 Trade Theories
UNIT 4 TRADE THEORIES
Objectives

After reading this unit you should be able to:

 understand the analytical foundations of international trade;

 know how the nations decide their trade policy;

 understand different trade theories; and

 know FDI approaches to international trade.

Structure

4.1 Introduction
4.2 Classification and Importance of Trade Theories
4.3 International Trade Theories
4.4 Heckscher-Ohlin Theory
4.5 Foreign Direct Investment (FDI) Theories
4.6 Summary
4.7 Key Words
4.8 Self-Assessment Questions
4.9 References /Further Readings

4.1 INTRODUCTION
From ages to civilizations; world history is essentially a story of wars and trade. Major
wars were primarily fought mainly for economic reasons rather than conflict of political;
cultural or social ideas. For examples; Britons set up their colonies world over for
trade; U. S. invaded Iraq and Libya mainly for economic reasons. Africa was colonised
for trade and commerce so was the story of Latin America. Historians, World over,
generally believe that most of wars were fought for trade-related reasons. Theories of
international trade and its applications help us understand the motives and reasons
behind such wars explaining trade pattern and the benefits that flow from trade. An
understanding of international trade theory helps us as investors or consumers, buyers
or sellers, companies and governments to determine how to act for their own benefit
within the global trading system.

4.2 CLSSIFICATION AND IMPORTANCE OF

TRADE THEORIES
International Trade Theories are broadly classified into following categories as shown
in Figure 4.1.

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International Trade

Figure 4.1: International Trade Theories

Firstly; international trade theory helps us explain the trade patterns; trade motives;
trade trends and observed trade. It helps us explain the characteristics of trade pattern
of a trading country, and from those characteristics it can be deduced what; why;
where and how they actually trade. Various trade theories provide us easy understanding
and explanations about reasons; characteristics and motives behind trade. Secondly,
trade theory also helps us understand and to know about the effects of trade on the
domestic economy/sectors of economy and helps diagnose cause and effect relationship
which in turn help the country policy makers to evaluate different kinds of policies. As
a result; government can plan for policy interventions to boost up trade and international
commerce and brining prosperity to country thus generating welfare in society.
International Trade Theories helps us understand that why do countries trade? Why
not a strong economy like United States of America should produce all goods and
services at back home rather than to import them from countries such as China and
India? Why do countries specialize in trade for example; a strong economy like Japan
import wheat, corn, chemical products, aircraft, manufactured goods, and informational
services from other countries. In nutshell; international trade theories attempt to solve
following questions as shown in Figure 4.2.

Figure 4.2 : Reasons for Studying International Trade Theories

Answer is that countries world over are endowed with different natural, human, and
capital resources. Each country varies from each other in combining these resources
(Land; Labor and Capital). In a globalized set-up each country cannot be efficient as
the best at producing the goods and services that their residents demand. As a result;
they have to trade off their decisions to produce any good or service based on opportunity
cost. Opportunity cost model helps us understand the “choice of producing one
good or another”. The production decision of the country will be dependent on
72 conundrum that it is more efficient to produce the goods and services with the lower
opportunity cost with increased and specialized production; to trade those goods; with Trade Theories
the goods of higher opportunity cost.

4.3 INTERNATIONAL TRADE THEORIES

International business began with international trade operations, which were facilitated
by the global economy’s laissez faire attitude. It improved the well-being of many
nations, and the position of trade barriers reduced trade gains, giving rise to the search
for alternative avenues to boost net exports. Alternative trade routes resulted in the
establishment of companies in foreign countries via FDI. In this context, it is critical to
comprehend the determinants and consequences of international trade and FDI on
trading partners, multinational corporations’ international operations, and the economies
of home and host countries. Several theories have been developed across countries
over time, which have served as the foundation for international trade and FDI.
Theory of Mercantilism
From the sixteenth to the eighteenth centuries, world trade was based on the economic
theory and practice of mercantilism, particularly in Western Europe, namely France,
England, and Germany. It included elements such as belief in protectionism, nationalism,
and the welfare of the nation. Furthermore, it included the planning and regulation of
economic activities in order to achieve national goals, as well as the reduction of imports
and promotion of exports. The trade revolution gave rise to a new economic concept
known as ‘Mercantilism.’According to this theory, agriculture practices have a very
limited impact on a country’s economic development because agriculture becomes
unproductive after a certain period of time. However, economic development through
the use of industries has no bounds.The mercantilists, primarily European countries,
believed that a nation’s power lies in its wealth, which grew by increasing gold and
silver reserves. This was thought to be possible by establishing a favourable trade
balance. This belief gained traction on the grounds that gold could be used to fund
military expeditions and wars, and that exports would create jobs in the economy.
Adam Smith and Ricardo criticized mercantilism theory by emphasizing the importance
of individuals and pointing out that their welfare was the welfare of the nation. They
believed in liberalism and defined national wealth as “the sum of enjoyments” of
individuals in society. Their trade doctrines were founded on the laissez faire principle
and specialization in the production of goods for which resources were most suitable
and easily available. The critics of mercantilism accepted any activity that would increase
people’s consumption. Mercantilists failed to recognize that export promotion and
import substitution are not possible in all countries, and that mere possession of gold
cannot improve people’s well-being. Keeping resources in the form of gold reduces
production of goods and services, lowering the welfare of citizens. The concentration
of production of goods for domestic consumption through less efficient use of resources
will result in less production and lower gains from international trade.
Theory of Absolute Cost Advantage
Adam Smith advocated the theory of absolute cost advantage. Many factors influence
bilateral trade between the two countries, including transportation costs, tariffs, internal
and external factors, national and international aspects, and so on. Every country should
invest in the production of the commodity that it can produce more cheaply than the
other country and exchange it for the commodity that is less expensive in the other 73
International Trade country. Keeping all the variables constant, the following are the assumptions of the
absolute cost advantage theory:
 Labor is the only factor of production that is used in the production of goods;
 The cost of production is the cost of labour; the skill of labour is the same in
both countries; and
 The factor of production, labour, is perfectly mobile.
There is free trade between countries, which means that trading countries do not have
to pay any tariffs; additionally, there are constant returns to scale, and technical progress
is also found to be constant. Finally, both countries manufacture the same commodity.
The example in Table 4.1 will help you better understand the theory:
Table 4.1: Labour Cost of Production (in Hours)

Country Labour Cost Per Day (in hours)

Tractor Truck Before After

Trade Trade

India 10 5 15 20

France 5 10 15 20

According to this theory, trade between the two countries will take place only when
there is an absolute cost difference between the goods produced by the two countries.
Prior to trade, India produced 10 tractors and 5 trucks. At the same time, France
produced 5 tractors and 10 trucks. If these two countries trade, they will specialize in
terms of absolute advantage and gain from trading with each other. India has an absolute
cost advantage in tractor production, while France has an absolute cost advantage in
truck production. India can produce 10 tractors and only 5 trucks in one hour of
labour. However, in the case of France, the situation is the inverse. If both countries
produce both goods, they will be able to trade in that condition. Only 15 tractor and
truck units are manufactured. At the same time, if India and France engage in
international trade with their specialized goods, they can produce 20 units of each. It
means that India, which has an absolute cost advantage in tractor production, will
produce tractors, while France, which is specialized in trucks, will produce only trucks.
Theory of Comparative Cost Advantage
Adam Smith’s theory of absolute advantage failed to explain the basis of trade when a
country has an absolute advantage in producing both goods. To address this issue,
David Ricardo in 1817 explained that if both trading countries do not have an absolute
advantage in either of the two goods, how can international trade take place? He
emphasized that a cost advantage for both trading countries is not required for trade to
occur. Even if one country can produce all goods at a lower labour cost than the other,
it would still benefit both trading countries.
Table 4.2 : Labour Required for Producing One Unit

Country Jute Leather

India 120 100

France 80 90
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The Table 4.2 shows that France has an absolute cost advantage in the production of Trade Theories
both goods, namely jute and leather, when compared to India. India has a comparative
cost advantage in the production of leather, while France has a comparative cost
advantage in the production of jute. However, this means that India needs 100 men
per year to produce leather and 120 men to produce jute. On the other hand, the same
amount of Jute and Leather France requires 80 and 90 labours, respectively. As a
result, India employs more labour than France in the production of jute and leather. In
other words, France is more capable than India in producing both goods, and it has an
absolute advantage in the market. Nonetheless, France would benefit more from jute
production and will export it to India because it has a greater comparative advantage
in it. It is due to the fact that the cost of producing Jute (80/120 labour) is less than the
cost of producing Leather (90/100 labour). At the same time, India will shift its
production to leather production because the country has the least disadvantage.
International trade will benefit both countries in this manner.
Haberler’s Theory of Opportunity Cost
Ricardo’s theory of comparative cost advantage was criticized because it was based on
the labour theory of value. According to the labour theory of value, the value of a good is
equal to the amount of labour time involved in its production. Ricardo discovered that
labour was the only factor of production, that it was homogeneous, and that it was used
in fixed proportions in the production of all commodities. Although all of these assumptions
were found to be unrealistic because there are other factors of production besides labour,
labour cannot be used in uniform proportions, and labour can be substituted with capital
in countries where capital is cheaply available. Because of these flaws, Haberler developed
his theory of Opportunity Cost. According to the theory, if a country produces either A or
B commodity, the opportunity cost of commodity A is the amount of commodity B
sacrificed in order to obtain an additional unit of commodityA. Nonetheless, the exchange
ratio of the two goods is expressed in terms of opportunity cost. Along with the production
possibility curve, the concept has been used in international trade theory. Haberler’s
theory is based on the following assumptions:
 There are only two trading countries, each of which has two factors of
production, namely labour and capital;
 Each country produces two goods;
 There is perfect competition in the factor and goods markets;
 There is full employment in both countries, factors are immobile between the
two countries but completely mobile within the country;
 Trade between the countries was assumed to be free; and
 The supply of goods was assumed to be unlimited.
According to the theory, a production possibility curve (PPC) depicts various alternative
combinations of the two commodities that a country can produce more efficiently by
utilizing both factors of production and the technology at hand. The slope of PPC
calculates the amount of one good that a country must give up in order to obtain an
additional unit of another good. The slope of PPC, on the other hand, explains the
marginal rate of transformation (MRT). Haberler’s theory was thought to be superior
to the comparative costs theory of international trade. Its superiority stems from an
examination of pre-trade and post-trade conditions under constant, increasing, and
decreasing opportunity costs, whereas comparative cost theory was founded on 75
International Trade constant production costs within a country and comparative advantage and disadvantage
between the two countries. Despite its contributions to international trade, Jacob Viner
has criticized the theory of opportunity cost on the following grounds:
 The opportunity costs approach was found to be inferior as a tool of welfare
evaluation to the classical real cost approach, as the theory fails to measure
real costs in the form of sacrifices made in providing productive services.
 Viner also criticized the PPC for failing to take into account changes in factor
supply, and the assumptions of two countries, two commodities, two factors,
and perfect competition were also found to be unrealistic.
Mill’s Theory of Reciprocal Demand
J. S. Mill applied Ricardo’s concept of comparative cost. This means that labour
productivity varies by country. According to Mill, reciprocal demand is the ratio in
which two commodities are traded based on the strength of demand elasticity in both
countries for both A and B commodities. J.S. Mill used the concept of an offer curve in
his theory. Although, Marshall and Edgeworth introduced the concept of offer curves,
the theory is predicated on the following assumptions:
 There are two countries, two goods, and two factors of production;
 It is based on the comparative cost principle, there is perfect competition,
and there is full employment; goods are produced under constant returns.
The theory can be explained using the example given in Table 4.3 based on the above
assumptions:
Table 4.3 : Quantities of Commodities Produced

Country Linen Jute

France 10 10
Italy 6 8

Assume France produces 10 units of linen or jute in one year, whereas Italy produces
6 units of linen or 8 units of jute with the same labour and time factors. According to
J.S. Mill, “It will benefit Italy to import linen from France and France to import jute
from Italy.” It is because France has an absolute advantage in both the production of
linen and jute, while Italy has the least comparative disadvantage in the production of
jute. Prior to entering into trade with each other, France’s domestic cost ratio was 1:1,
and France’s domestic cost ratio was found to be 3:4. However, if they trade with
each other, France has a 5:3 (or 10:6) advantage over Italy in the production of linen,
while Italy has a 5:4 advantage in the production of jute (or 10:8). Nonetheless, 5/3 is
greater than 5/4. In the production of linen, France has a greater comparative advantage.
As a result, France will benefit from exporting linen to Italy in exchange for jute. Similarly,
Italy’s position in the production of linen was determined to be 3/5 (or 6/10), while its
position in the production of jute was estimated to be 4/5 (or 8/10). However, 4/5 is
greater than 3/5, so it is advantageous for Italy to export Jute to France in exchange for
Linen. Nonetheless, Mill’s theory of reciprocal demand is concerned with the possible
trade terms under which the two goods were exchanged between the two countries.
However, the terms of trade refer to the barter terms of trade between the two countries,
i.e. the proportion of a country’s imports to its exports. Furthermore, the domestic
exchange ratios recognized by the relative efficiency of labour in both countries set the
76 limits of possible international trade barter terms. However, it is clear from the example
(Table 4.3) above that France, with two labor-time inputs, produces 10 units of linen Trade Theories
and the same number of units of jute, whereas Italy, with the same labour time, can
produce 6 units of linen and 8 units of jute. However, in France, the domestic exchange
proportion between linen and jute is 1:1, while in Italy, it is 1:1.33. As a result, the
maximum possible terms of trade in France were 1 Linen: 1 Jute, while in Italy it was
calculated to be 1 Linen: 1.33 Jute. As a result, the trade terms between the two goods
were determined to be 1 Linen or 1 Jute or 1.33 Jute.
Activity 1
Choose two countries of your choice producing wheat and rice. Compare their
absolute advantage and disadvantage.
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4.4 HECKSCHER-OHLIN THEORY

Heckscher-Ohlin trade theory was another name for the Heckscher-Ohlin trade model.
Heckscher published a paper in 1919 in which this theory was presented, but Ohlin
published a book in 1933 in which this model was presented. Furthermore, Ohlin was
awarded a Noble Prize for his theory in 1977. This model is also known as the H.O
Model. The model is 2x2x2 because it consists of two goods, two production factors,
and two countries. Capital and labour are the two factors. Ricardo failed to explain
how comparative advantage is determined. According to this theory, a country will
export commodities with abundant factors and import commodities with scarce factors.
However, in Adam Smith and Ricardo’s trade models, labour was the only factor
input, and the differences in the trade is determined by labour productivity. They pointed
out that different countries have different factor endowments, and that the differences
in factor endowments facilitate trade between trading partners. The theory is based on
the assumption that there are trade barriers and that goods and factor markets are
perfectly competitive. Furthermore, the theory is predicated on comparative advantage
in terms of relative factor prices. As a result, if a country has a large amount of capital,
it will produce capital-intensive products and export them in exchange for labor-intensive
products. While another country, which is rich in labour, will produce and export labor-
intensive goods. Despite this, it will import capital-intensive goods. The term “abundance”
has two meanings in this theory: it refers to the price of the factor and it refers to the
physical quantity of the factor. If there are two countries, A and B, then the prosperity
of the country in terms of factor prices means that the price of the factors of production
is relatively lower.
Unlike the classical trade model, H.O. trade theory cannot guarantee the desired income
distribution among the country’s various classes. Because of the greater demand for
producing respective goods for the global market, returns to capital are higher in country
A and returns to labour are higher in country B. The traditional trade models were
predicated on certain assumptions, such as no transportation costs and the free flow of 77
International Trade information to all producers and consumers. They do not account for the effects of
trade on global prices. These trade theories are static and ignore the effects of
technological progress on global economic growth. These are real concerns that must
be addressed in a customized description of classical and neoclassical theories. If a
country has a monopoly on a particular good, it can have an impact on global prices. It
can either supplement its gains through “optimal tariffs,” which seek to maximize the
welfare of the country. Trade has the potential to complicate the growth process. It can
have an impact on employment and even the overall well-being of the country. This is
possible in the case of exponential growth (when benefits from the higher output are
neutralized by the adverse terms of trade). The country ends up with lower real income
after growth because the benefits of higher output are washed out by deteriorating
trade terms. However, it should be noted that the adapted version of the basic theory
does not change the assumption that a country produces and exports the product in
which it has a comparative advantage, and uses the abundant factor in the production.
The country benefits from trade, but the distribution of gains can be distorted. Change
in trade is not free, but the short-term cost of adjustment should be balanced against
the long-term benefits of trade.
The theory was criticized on the following grounds: the assumption of 2x2x2 model
was found to be unrealistic; unlike classical theory, this theory was also static in nature;
the theory was based on the assumption of homogenous factors which was calculated
with the help of factor endowment; the techniques of production cannot also be
homogenous even for the same good in the two countries as assumed in H.O. model;
the theory is based on another assumption of similar taste. The theory was based on
the assumption of constant returns to scale, which is also not true because a country
with a rich factor endowment frequently obtains the benefits of economies of scale
through a smaller amount of production and exports, implying that there should be
increasing returns to scale; the theory does not take into account transport costs in
trade between trading countries; the impractical supposition of full employment and
perfect competition; the Leontief paradox has been proven.
The Leontief Paradox
Wassily Leontief conducted an input-output analysis using data from the United States in
1947 to validate the Heckscher-Ohlin model. He divided 200 industries into 50 sectors,
38 of which were discovered to be trading their goods directly on the international market.
Leontief discovered a paradoxical situation in which the United States was importing
capital-intensive goods from abroad despite being a capital-rich country and was found
to be exporting labor-intensive goods. The supporters of H.O. trade theory experienced
a slowdown in the early 1950s, when Leontief tested his hypothesis using data from the
US economy. His findings refuted the H.O. claim. It was shocking news for economists
that the United States, despite being a capital-rich country, was exporting labor-intensive
goods a several explanations were considered in order to resolve the Leontief paradox.
The following significant factors were identified as supporting the Leontief paradox: the
United States’ protective trade policy, the import of natural resources, and the investment
in human capital. William Travis investigated Leontief theory in the context of US tariff
policy.When Leontief tested his hypothesis, the United States was found to be importing
more capital-intensive items such as crude oil, paper pulp, primary copper, lead, metallic
ores, and newsprint. Thus, according to Travis, the United States’ protective trade policy
was to blame for Leontief’s findings.
The United States imports natural resources such as minerals and forest products and
78 exports farm products, according to Leontief’s presentation. Human capital investment
boosts labour productivity. Because of these factors, the United States’ exports were Trade Theories
labor-intensive, whereas its imports were capital-intensive and importing capital-intensive
goods. Leontief analysis was also found to be flawed on statistical and methodological
grounds. The main points of criticism were: the year 1947 was not a normal year for
testing the H.O. Model because of World War II, as the United States was the only
major industrial country that was not destroyed by war; economists criticized the
aggregation used in the input-output model for computing capital-labour ratios in some
way; it was argued that Leontief model with fixed input coefficients was found to be
mismatched with world trade equilibrium in which every country achieves.

4.5 FOREIGN DIRECT INVESTMENT (FDI)

THEORIES
Despite Multinational Enterprises’ dominance of world production and trade in the
post-World War II period, the search for FDI theories is a contemporary phenomenon.
Stephen, H. Hymer demonstrated in his doctoral thesis ‘The International Operations
of National Firms: A Study of Direct Investment’ (published in 1976) that traditional
theories of international trade and capital movements were incapable of illuminating the
contribution of MNEs in foreign countries in 1960. The existence of MNEs was due to
local firms manipulating market power and acting as agents. The approaches used to
clarify the activities of multinational enterprises have been classified into four groups.
The first is the market imperfection approach, whose theoretical framework considers
specific, also known as ownership advantages, enjoyed by an enterprise. Through
these benefits, FDI is restricted, and international companies also collude with other
firms to increase their profits. Second, the Product Life Cycle model examines various
stages of the company. There are chronological stages in the life cycle of a company’s
innovated products. Third, the failure of traditional theories of international trade and
capital movements based on the assumption of perfect competition, as well as its
prevalence in various segments of the international market, provide ample scope. It
gave rise to the transaction cost theory of FDI, which states that firms make foreign
investments to increase their competence and reduce transaction costs. Finally, the
eclectic paradigm that surrounds other FDI theories provides a logical framework for
conducting empirical investigations that are most relevant to the problem at hand. The
eclectic paradigm is not a theory in itself, but rather a synthesis of contradictory theories.
Market Imperfections Approach
The expansion of MNEs has always perplexed neoclassical economists because of
how these enterprises can make profits in foreign countries where production costs
are higher than in the domestic market. Because many people were unaware of the
host country’s history, it was difficult to take advantage of the situation. It may be
preferable for the foreign company to pass on its reward to local entrepreneurs, who,
along with other local (inherent) advantages, could supply at a lower cost than the
foreign investors. The response to this paradoxical situation was present in the existence
of the imperfect market in the foreign countries. Hymer presented a case for market
imperfection approach. According to him, the traditional theories of international trade
and capital movements were not enough to explain the association of MNEs in
international market. Their presence was observed to be due to market imperfections.
The supporters of this approach thought that the prevailing market imperfections were
‘structural’ (imperfections of monopolistic nature) and arose from the innovation of
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International Trade better technology, access to capital, control of distribution system, economies of scale,
differentiated products (by the introduction of different advertising methods) and
improved management. All these factors facilitated the foreign enterprises more than
offset the shortcomings from their operations in the foreign market and the additional
cost incurred there.
Hymer was primarily concerned about the market power of MNEs, which limited the
entry of other firms. Market power is the result of collusion with others in the industry
to avoid competition, resulting in higher profits. There is a one-way casual link between
the firm’s behaviour and the imperfect market structure. Market power was first
developed in the home country, and as profit margins in the home country shrank, the
firm invested abroad and gained control of the foreign market through patent rights.
Because the profit margin in the home country has decreased, the firm invests abroad
and controls the foreign market through patent rights.
The Eclectic Paradigm
This theory on FDI was proposed by John H. Dunning in 1979. Eclectic Paradigm has
three components:
 OLI Model (ownerships, locations, and internationalization).
The theory assumes that institutions will avoid transactions in the open market if the
cost of performing the same actions internally is lower.
Ownership Advantage - This term refers to the competitive advantages of enterprises
seeking FDI. The greater the investing firms’ competitive advantages, the more likely
they are to engage in this foreign production.
Locational/Geographical Attractions - Locational/Geographical Attractions refer
to alternative countries or regions for MNEs to undertake value-added activities. The
more immobile, natural, or created resources that firms must use in conjunction with
their own competitive advantages favour a presence in a foreign location, the more
firms will choose to augment or exploit their specific advantages through FDI.
Advantages of Internationalization- Firms can organize the creation and exploitation
of their core competencies. The greater the net benefits of internationalizing cross-
border intermediate product markets, the more likely it is that a firm will prefer to
engage in foreign production itself rather than licensing the right to do so to others.
In a nutshell, the theory states that if a company does not have an ownership advantage,
it will conduct its operations in the domestic market and will not seek FDI. If, on the
other hand, ownership advantage is available, the firm will examine whether it has a
locational or geographical advantage; if it does not, the firm will produce in its home
country and export its goods to other countries. Finally, it will examine the benefits of
internationalization and determine which process is the most cost effective, whether to
carry out production activities in the host country or to give the license to another
country, and whether or not to pursue FDI.

Activity 2
List the differences between international trade theories and FDI theories.
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 Trade Theories
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4.6 SUMMARY
The rational structure of international business is built around the activities of MNEs,
which are explained by the internalization process. Prior to the advent of multinational
corporations, the terms foreign trade and international business were simply
interchangeable. The international transactions were directed by international trade
doctrines based on labour cost differentials and free trade. MNEs’ innovative efforts,
technological development, and management styles have rendered international trade
theories obsolete. Theorists began to develop FDI approaches in support of international
business for the enhancement and welfare of the world economy.
Several theories have been developed over time to explain the foundations of
international trade and FDI. The doctrine of mercantilism was the first in international
trade. Its underlying assumption was that a country could become wealthy by acquiring
gold from abroad, which could only be accomplished by increasing exports and
decreasing imports. They were most concerned with the national interest. Adam Smith
and David Ricardo opposed mercantilist ideas on the grounds that the gains of individuals
were the gains of the nation, and any action that increased the consumption of the
people should be viewed favourably.
The investigation of FDI theories is a relatively a new phenomenon. Hymer discussed
in his doctoral dissertation in 1960 that traditional theories of international trade and
capital movements were unable to explain the association of MNEs with foreign
countries. There are four types of FDI approaches. The first is the market imperfection
approach, which assumes that MNEs have certain ownership advantages and control
FDI through them. The proponents of this approach believed that the existing market
imperfections were monopolistic structural imperfections that arose as a result of factors
such as innovation, superior technology, access to capital, distribution system
management, economies of scale, differentiated products, and improved management.
All of these factors aided MNEs in compensating for the disadvantages of their
operations in foreign environments.

4.7 KEY WORDS

Absolute Advantage : Greater advantage or efficiency in the
production of goods enjoyed by one country
over another country. This is the basis of
trade according to AdamSmith.
Basis of Trade : Factors that help in international trade.
Gains from Trade : Gains arising from international trade which
takes place on account of specialization
advantages of the trading partners.
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International Trade Comparative Advantage : It states that trade would still be gainful even
if one country is less efficient than the other,
but specializes in the production of
commodities or goods where its
disadvantages are relatively lower
(comparative advantage) and exports the
same.
Production Possibility Curve (PPC) : It shows the various possibilities of
production of two goods in a country, given
the factor endowments and technology.
H.O. Trade Theory : Postulation that countries specialize in the
production and export of those goods which
require their abundant or cheap factors. A
capital rich country exports capital intensive
goods and imports labour intensive goods.

4.8 SELF-ASSESSMENT QUESTIONS

1) Explain the theory of mercantilism. Can it be applied in the present context?
2) Examine the implications of AdamSmith’s theory of absolute cost advantage.
3) Critically examine Ricardo’s comparative cost theory of international trade.
4) Discuss the Heckscher-Ohlin Trade Model.
5) Discuss the Market Imperfections Approach. How do the company specific
advantages help the formulation of this theory?
6) What is eclectic paradigm? Discuss the applicability of this model in current
scenario.

4.9 REFERENCES/FURTHER READINGS

Krueger, A. O. (2020). International Trade: What Everyone Needs to Know. USA:
OUP.
Krugman, P., Melitz, M., and Obstfeld, M. (2018). International Trade: Theory
and Policy. Pearson.
Suranovic, S. (2010). International Trade: Theory and Policy. Saylor Foundation.

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 Trade Theories
UNIT 5 WTO AGREEMENTS
Objectives

After reading this unit, you should be able to:

 briefly discuss the General Agreement on Tariffs and Trade (GATT);

 explain the structure of World Trade Organization;

 discuss the key agreements of WTO;

 explain the trade policy review mechanism; and

 understand India’s experience under WTO trade regime.

Structure

5.1 Introduction
5.2 Structure of WTO
5.3 Principles of WTO
5.4 Framework Agreements of WTO
5.5 Key Agreements of WTO
5.6 Evolving Trade Issues at WTO
5.7 Trade Policy Review Mechanism
5.8 India’s Experience under WTO Trade Regime
5.9 Summary
5.10 Key Words
5.11 Self-Assessment Questions
5.12 References/Further Readings

5.1 INTRODUCTION
The General Agreement on Tariffs and Trade (GATT) was a multilateral treaty that
laid down agreed rules for conducting international trade. It came into force in
January1948. Its basic aim was to liberalize trade and for 47 years it had been
concerned with negotiating the reduction of trade barriers and maintaining
international trade relations. Overseeing the application of its rules was an important
and continuing part of its activities. GATT also provided a forum in which countries
could discuss and overcome their trade problems and negotiate to enlarge
international trading opportunities. The rapid and uninterrupted growth in the volume
of international trade till 1994 is attributed to and is taken as an indicator of the
success of the GATT. The various rounds of GATT negotiations which finally led
to formation of WTO as a permanent body in 1995 are provided in Table 5.1 as
under: 83
International Trade Table 5.1: Rounds of Trade Negotiations under GATT to Formation of WTO

Year Name of Place Subjects Covered Countries

1947 Geneva Tariff 23

1949 Annecy Tariffs 13

1951 Torquay Tariffs 38

1956 Geneva Tariffs 26

1960-61 Geneva (Dillion Round) Tariffs 26

1964-67 Geneva (Kennedy Tariffs and Anti-Dumping

Rounds) Measures 62

1973-79 Geneva (Tokyo Round) Tariffs, Non-Tariffs and 102

“framework” agreements

1986-94 Geneva (Uruguay Tariffs, non-tariff measures, 123

Round) rules, services, intellectual
property, dispute settlement,
textiles, agriculture, creation
of WTO, etc.

1994 Geneva (Marrakesh Formation of permanent body,

Declaration) WTO, came into existence on
January, 1995

Source: World Trade Organization, 2022.

The WTO was established on January 1, 1995. WTO is a successor of the GATT
Uruguay Round. Seventy Six Governments became members of the WTO on its first
day. As on December 2021, there were 64 members of the WTO and it represents
almost 98% of world trade. Over 20 countries have an observer status and are in
process of joining the WTO. WTO is an inter-governmental organization and it is
based in Geneva, Switzerland. The key functions of WTO are:

i) Administering and implementing the multilateral and plurilateral trade

agreements which together make up the WTO;

ii) Acting as a forum for multilateral trade negotiations;

iii) Seeking to resolve trade disputes.

iv) Overseeing national trade policies; and

v) Cooperating with other international institutions involved in global policy-

making.

The distinction between GATT and WTO are presented in Table 5.2.

84
 Table 5.2: Distinction between GATT & WTO WTO Agreements

S.R. Specific GATT WTO

No. Areas
1 Institutional No institutional foundation, Permanent institution with its own
Foundation only a small associated Secretariat.
Secretariat.

2 Level of Provisional basis, no Full and permanent commitment.

Commitment permanent commitment.

3 Agreement Multilateral agreement. Multilateral agreement with

commitments of entire
membership.

4 Dispute Slower, less automatic, Faster, automatic, less blockages,

Settlement more blockages, dispute dispute findings easily assured.
System findings not easily assured.

5 Membership Less global. More global.

6 Policies Tolerated policies of Reversed policies of protection in

protection in certain certain sensitive areas.
sensitive areas.

7 Scope Mainly dealt in trade in Covers goods, services and

goods. intellectual property.

Activity 1

How is WTO different from GATT in its functioning?

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5.2 STRUCTURE OF WTO

Let us now discuss the organizational structure of WTO for understanding the system
of governance under WTO.
As discussed above, World Trade Organization came into existence on January 1,
1995 after replacing the previous GATT. Now, WTO secretariat is fully responsible
for administering the international trade regime among member countries. The
organization structure of WTO is illustrated in the Exhibit 5.1 as under:

85
International Trade Exhibit 5.1 : Organizational Structure of WTO

Source: https://www.wto.org/english/thewto_e/whatis_e/tif_e/org2_e.htm

Following are some of the important organs of WTO organization structure and are
explained as under:
1) The Ministerial Conference: It is the supreme body involving the trade
ministers from all member countries. All trade negotiations are concluded and
agreed at Ministerial Conference only. It is also the apex governing body of
the WTO that is responsible for setting the strategic direction of the organization
for trade negotiations, rules setting and concluding agreements. All final
decisions relating to various aspects of trade agreements are taken here. The
Ministerial Conference must meet at least once every two years however,
meeting can be called earlier also depending on urgency and needs of member
countries. In majority of the cases, the decisions are taken on the basis of
consensus but voting can take place on certain issues as it is difficult sometimes
to reach to consensus on the trade body comprising 164 member countries,
having diverse economic interest and priorities.
2) The General Council: General Council is composed of senior country
representatives who are usually at the level of ambassador from all
members’ countries. General Council is the most important organ of WTO
as it is responsible for overseeing the day-to-day business and management
of the WTO. General Council meetings take place usually at WTO
headquarters in Geneva but sometimes retreat meetings take place to
86 discuss the subject matter informally. Practically it is the key decision-
 making arm of the WTO for most trade negotiations and other issues. All WTO Agreements
other bodies except Minsters (Ministerial Conference) report their business
directly to the General Council.
3) The Trade Policy Review Body: TPRB consists of all the WTO members
and is responsible for looking after the Trade Policy Review Mechanism as
agreed in Uruguay Round of trade negotiations. It has the mandate to
periodically review the trade policies and practices of all member states. Trade
Policy Review Reports are important in the sense that it indicates how member
countries are implementing their obligations and commitments made under
various trade agreements. It aims at improving the adherence of member
countries for commitments and obligations agreed under agreements of WTO.
4) The Dispute Settlement Body: This body comprises of all 164 member
countries of WTO. It is responsible for looking after the implementation and
effectiveness of the dispute resolution process for all WTO agreements including
the issues relating to implementation of the decisions on WTO disputes. Trade
disputes of member countries are heard and ruled on by dispute resolution
panels which are carefully chosen individually for each case. In case of
grievance, member country can go to permanent Appellate Body that was
established in 1994. The decisions made by Dispute Settlement Body are
mandatory and binding on all members and should be accepted in letter and
sprit by member countries.
5) The Councils on Trade in Goods and Trade in Services: It operates
under the mandate of the General Council and consists of all members’
countries. It is tasked to oversee the details of the general and specific
agreements on trade in goods and services. For example, it is mandated to
oversee the implementation of agreements on textiles and agriculture which
are extremely vital to member countries due to higher export intensity of textile
industry and employment generation. Council on Trade in Goods and Services
is also mandated to look-after the progress on “Agreement on Trade-Related
Aspects of Intellectual Property Rights”.
6) The Secretariat: The Secretariat of WTO is based at Geneva and is headed
by the Director General. There are staffs of over 600 employees in the
Secretariat which comprises the legal expert, economist, trade analysts and
counsellors and communication experts. Secretariat is responsible for all
administrative functions aimed at smoothly and systematically running the
organization. Although, the Secretariat has no legal decision-making powers
but it provides vital services for taking the negotiations agenda forward.

5.3 PRINCIPLES OF WTO

The formation of WTO has come on certain principles (Figure 5.1) which were agreed
among member countries during various stages of trade negotiations in different rounds
of GATT. As WTO agreements are lengthy and complex involving legal texts and
covering a wide range of interrelated and interconnected activities having far reaching
impact from one to another. It becomes tough sometimes to understand that where the
source of problem or solution itself lies may become a problem due to such interrelated
activities. There are number of simple and fundamental principles which help us
understand the guiding tenets through which these WTO agreements are negotiated 87
International Trade and implemented. These principles are the foundation of the multilateral trading system
and are briefed as under:
a. Non-Discrimination: Most important principle of WTO which states that
no country should discriminate between its trading partners and it should
also not discriminate between its own and foreign products, services or
nationals.
b. More Open: WTO functioning is based on the principle of more open manners
this lowering trade barriers is one of the most obvious ways of achieving
economic globalization among member countries. Trade Openness encourages
trade by reducing the customs duties or tariffs and non-tariff measures like
import bans or quotas or SPS/TBT.
c. Predictable and Transparent: WTO rules ensures predictable and
transparent trade regime among member’s countries. Foreign companies,
investors and governments when trading with other countries or making an
investment decision in another country, can be confident that trade barriers
should not be raised arbitrarily by host country. Thus, WTO rules bring more
stability and predictability in trading and investment regime among member
countries encouraging foreign investor, companies and governments to
investment more, trade more. These have spill over effects in the market and
help create jobs, increased market consumption and higher growth in GDP of
the country.

Non-discrimination
More open

Protect the environment

PRINCIPLES OF
WTO More beneficial for less developed countries
More competitive

Predictable & transparent

Figure 5.1: Principles of WTO

d. More Competitive: WTO rules discourages unfair, unlawful and restrictive

trade practices such as quota regime, export subsidies and dumping of products
at below cost to gain market share in target country. WTO rules and procedures
lay down clear cut rules defining what is fair and what is unfair and pass its
verdict which the member country should obey.
e. Protect the Environment: Degrading environment is a major concern before
our society and WTO’s agreements and rules has provision that member
countries can take necessary steps to protect not only the environment but
also public health, animal health and plant health. As WTO preaches non-
discrimination, these measures must be applied in the same way to both national
and foreign businesses. No county shall be allowed to use environmental
protection measures as a means of disguising protectionist policies to control
imports or provide protection to domestic industry.
88
 WTO Agreements
Activity 2
What are guiding principles of WTO? How far WTO has been able to implement
them? Examine this in context of India.
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5.4 FRAMEWORK AGREEMENTS OF WTO

Let us now focus on understanding the various agreements of WTO shaping the global
trade order.
The framework agreements are the guiding pillars for understating the basic structure
of the WTO agreements. There are three main areas (goods, services and intellectual
property) but have several agreements under them. For example, there are several
agreements falling under the framework agreement on Goods, the guiding principles
for which are originating from GATT agreement. The comprehensive framework of
WTO agreements (Table 5.3) can be understood in the broad pillars, such as, the
umbrella WTO Agreement on goods, services, intellectual property, disputes settlements
and trade policy reviews.
Table 5.3: Framework Agreements Establishing WTO

Umbrella Agreements Establishing WTO

Goods Services Intellectual

Property

Basic Principles GATT GATS TRIPS

Additional Other Goods Agreements Services Annexes

Details & Annexes

Market Countries’ Schedules of Countries’ Schedules

Access Commitments of Commitments (and
Commitment MFN exemptions)

Dispute Dispute Settlement Mechanism

Settlement

Transparency Trade Policy Reviews

Source: WTO, accessed at https://www.wto.org/english/thewto_e/whatis_e/tif_e

utw_chap2_e.pdf

5.5 KEY AGREEMENTS OF WTO

Let us now understand the key agreements of WTO and their implications.
Agreement on Tariffs : It is one of the foremost agreements of WTO. The agreement
on Tariffs is aimed at bringing more bindings and closer to zero, i.e. reducing the tariffs 89
International Trade and bringing them to a level where they remain to be used for the purpose of revenue
and should not act in trade distortion. Agreement on Tariffs is one of the bulkiest
documents of Uruguay Round of trade negotiations, and is estimated to be of around
22500 pages, listing individual countries’ commitments on specific categories of goods
and services.
The agreement includes the commitments to cut and “bind” the customs duty rates on
imports of goods of member-countries. In some cases, tariffs are being cut to zero.
The agreement explains the following concepts on tariffs.
 Most-Favoured Nation Tariffs: MFN tariffs refer to tariff-rate that each
member-states of WTO will apply on imports from other members of the
WTO, unless the country is part of a preferential trade agreement. In other
words, the MFN rates are the highest or the most restrictive tariff rates that
WTO members charge one another.
 Preferential Tariffs: Preferential tariffs are the lower tariff commitments
made by member-state of a preferential trade agreement that each member-
state will apply. They are always lower than MFN duties.
 Bound Tariffs: Bound tariffs refers to the specific commitments which are
made by the individual WTO member governments to WTO that bound tariff
will be the maximum MFN tariff level for a given commodity line which it can
apply.
 Applied Tariff: Applied Tariffs refers to the tariff-rates which are actually
applied on imports of a particular item or goods.
Agreement on Agriculture: The Agreement on Agriculture of WTO is aimed to
reform agricultural trade and frame the policies that are more market-oriented. The
underlying objectives of WTO Agreement of Agriculture are to improve predictability
and security for importing and exporting countries thus creating a fair market system.
The Agreement on Agriculture has following rules and commitments to apply:
 Market Access: aimed at various trade restrictions confronting imports in
letter and spirit of inherent principles of GATT.
 Domestic Support: aimed at reducing and finally eliminating the market-
distorting subsidies and other programmes, including those that raise or
guarantee farm-gate prices and farmers’ incomes.
 Export Subsidies: aimed at restricting the export subsidies and other methods
used to make exports artificially competitive.
The agreement on agriculture has certain provisions that allow the governments to
support their rural economies. It however asks for a policy regime which is facilitative
to farmers but should not lead to distortion in trade of agricultural products. The
outcome is that subsidies can be for ensuring subsistence farming etc. but should not
lead to price-distortion in the international markets. This agreement has challenges
for a developing country like India where majority of livelihood are based on
agriculture. If government of India reduces or cut the subsidies, it will result in several
socio-economic issues. Some provisions of this agreement are vague as they fail to
address the issue of huge agricultural subsidies offered by developed countries to
their farmers.
90
General Agreement on Trade in Services: The General Agreement on Trade in WTO Agreements
Services (GATS) is one of the most comprehensive and multilateral framework governing
the international trade in services. Services constitute the ever-growing share in sectoral
contribution of developed as well as developing countries. It was first negotiated under
the Uruguay Round and is framed to address the huge growth of the services economy
in the world trade. Trade in Services, is indeed, an opportunity for world economy as
services trade can be leveraged as a catalysing force for expanding the global trade,
growth, employment and other associated opportunities.
The General Agreement on Trade in Services has three elements which inter-alia are,
first the main text containing general obligations and disciplines; the second relates to
annexes dealing with rules for specific sectors, for instance air services, maritime services
and information technology services. Third and final is the framework of individual
countries’ specific commitments to provide access to their markets. It further includes
the indications of services where the member-states are temporarily not applying the
“most-favoured-nation” principle of non-discrimination.
In the context of above, the member countries of WTO have negotiated and drafted
the “General Agreement on Trade in Services” which is aimed at harmonization of
trade rules governing the exports and imports of services. General Agreement on Trade
in Services defines the trade in services into four modes of supply (Figure 5.2).

Source: World Trade Organization.

Figure 5.2 : Kinds of Mode of Supply of Services in Foreign Trade

Agreement on Trade Related Intellectual Property Measures: The framework

agreement on intellectual property is aimed at protection and enforcement of mutually
accepted rules of WTO. Trade-Related Aspects of Intellectual Property Rights (TRIPS)
measures were negotiated initially under the Uruguay Round of Trade Negotiations
(1986–94). The framework agreement of TRIPS specifies the following types of
intellectual property:
 Copyright and related rights
 Trademarks, including service marks
 Geographical indications
 Industrial designs
 Patents
 Layout-designs (topographies) of integrated circuits
91
International Trade  Undisclosed information, including trade secrets
Agreement on Trade Related Intellectual Property Measures broadly covers five broad
areas and these are:
 The manner under which the basic principles of the trading system and other
international intellectual property agreements should be applied among member
states.
 Describes the manner under which an adequate protection is given to the
intellectual property rights in world trade.
 Explains the procedure how member-states should enforce those rights
adequately in their own territories.
 Details the mechanism to settle the disputes, if any, on intellectual property
between members of the WTO.
 Provide the details on the special and transitional arrangements during the
period when the new system is being introduced.
Agreement on Anti-Dumping, Subsidies and Safeguards & Contingencies: The
revenue generated from tariff applied on imported and exportable goods is vital to
sustainable revenue receipt of any states. Accordingly, a tariff regime is place which
allows the nation-states to apply binding tariffs, and these are applied equally to all
trading partners under the guiding principles of Most-Favoured-Nation treatment of
WTO. The framework agreement on Tariffs however allows certain exceptions in
some circumstances. These include the following:
 Actions taken by member-state against the dumping of goods i.e. selling goods
at an unfairly low price.
 Subsidies and special “countervailing” duties to offset the subsidies as these
are justified considering the fair play between domestic and external market
players, and
 Finally, the emergency measures to limit imports temporarily. These are
designed to “safeguard” the domestic industries.
Framework Agreement on Non-Tariff Measures: Non-Tariff Barriers are “Policy
Instruments” aimed at restricting/prohibiting imports into a county. While tariff measures
bring revenue to government, makes imported goods expensive and priced out vis-a-
vis domestic goods, provide protection to domestic industry, discourage imports; Non-
Tariff Barriers, on the other hand, restrict/prohibit imports meaning that goods are not
allowed to be import cleared.
A standardized classification of the Non-Tariff Measures (NTM) was discussed and
agreed upon by several International Organizations in the context of the Multi-Agency
Support Team (MAST) appointed by The Secretary general of UNCTAD. Multi-
Agency Support Team, involving the group of eminent scholars, in consultation with
various international trade organizations and other associated stakeholders in exim-
value chain drafted a list of various trade measures that can act as barrier to
international trade. The standardized and harmonized classification of Non-Tariff
Measures is provided in Table 5.4. The structure of NTMs is broadly categorised as
under:
92
 WTO Agreements
Table 5.4: The Structure of The Non-Tariff Measures Classification

TECHNICAL
AFFECTING

MEASURES
BARRIERS
A: Sanitary and phytosanitary measures
IMPORTS
TARIFF

B: Technical barriers to trade

NON-

C: Pre-shipment inspection and other formalities

D: Contingent trade-protective measures

E: Non-automatic licenses, quotas, prohibitions,

Quantity-control measures
NON-TECHNICAL MEASURES

F: Price-control measures, taxes and charges

G: Financial measures

H: Measures affecting competition

I: Trade-related Investment measures

J: Distribution Restrictions

K: Restrictions on Post-Sales Services

L: Subsidies

M: Government Procurement restrictions

N: Intellectual Property

O: Rules of Origin
AFFECTING

MEASURES
EXPORTS

EXPORT

P: Export-related Measures
NTMs

Source: UNCTAD-MAST Team

The framework agreement on Non-Tariff Barriers deals with the following key issues:
 Import licensing
 Rules for the valuation of goods at customs
 Pre-shipment inspection: further checks on imports
 Rules of origin
 Investment measures
Plurilateral Agreement
In addition to the multilateral agreements, there are four plurilateral agreements as
negotiated, originally under the Tokyo Round but remained the part of Uruguay Round
and subsequently of WTO framework agreements. The four are:
 Trade In Civil Aircraft
 Government Procurement
93
International Trade  Dairy Products
 Bovine Meat
The bovine meat and dairy agreements were terminated in 1997.
Evolving Trade Regime on Standards & Safety
With the growing world trade and imports of foreign goods, there is concern for health
and safety issues among the consumers and Article 20 of the General Agreement on
Tariffs and Trade (GATT) have regulatory framework in place to deal with it. It allows
governments to act on trade issues in order to protect human, animal or plant life or
health, provided they do not discriminate or use this as disguised protectionism, for
instance, para 2.03 of India’s Foreign Trade Policy has provisions to protect public
order, health and safety by mandatorily implementing Indian standards on all imported
goods. Furthermore; there are two specific WTO agreements dealing with food safety
and animal and plant health and safety and with product standards in general. These
agreements try to identify the mechanism and methods on how to apply standards
including dealing with any issues of protectionism arising-out of such standards.
Activity 3
Identify the standards imposed by European Union on any of Indian exportable
products that restrict the market access?
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5.6 EVOLVING TRADE ISSUES AT WTO

Let us now understand some evolving issues that are addressed under the multilateral
trade system of WTO and are beyond the scope of specific trade agreements. These
issues primarily are arising from the framework agreements of WTO, i.e. GATT
agreement, GATS agreement and TRIPS Agreements.
Regional Trade Agreements
Regional Trade Agreements have increased in number as well as the complexity in their
formation due to ever-increasing proliferation of such grouping involving member
countries from different parts of the world. More so, the kinds of issues being covered
under the regional trade agreement has resulted in ever-increasing complexity, for
instance, standards, competition policy, government procurement, subsidies, intellectual
property, etc. The newer and emerging concerns from such Regional Trade Agreements
are addressed in various working committees of the WTO.
Trade and Environment
Climate change has emerged a new challenge that the entire mankind is facing. The
environment issues are now increasingly linked with trade issues and the most frequently,
the questions are asked by WTO members and also in various working committees /
94 groups in concerns related to climate change and environment arising out of trade issues.
Trade Facilitation and Investment-related Issues WTO Agreements

Singapore Ministerial Conference (1996) has decided to set up three new working
groups, the first on trade and investment, second on competition policy, and third on
transparency in government procurement. These issues were earlier never discussed in
trade parleys and these are aimed at identifying the possible ways of simplifying trade
procedures around these three areas. It is subsequently referred as the “trade facilitation
agreement”. The framework agreement on trade facilitation as agreed in Hong Kong
ministerial is a landmark agreement for simplifying the border procedure and other
involved issues.
Trade and Electronic Commerce
Online trade and commerce is increasing at high speed, completely transforming the
market landscape and involving channels of delivery. Electronic trade and commerce,
broadly speaking, has redefined the methods of production, advertising, sales and
distribution as each business process is happening through telecommunications
networks. For instance, the books, music and videos are transmitted down telephone
lines or through the Internet, which requires a new set of global rules and regulations to
deal with.
Trade and Labour Standards: The labour standards are another evolving area under
WTO trade regime. Labour standards refer to the way the workers should be treated
across the countries. It especially covers the wide array of issues such as use of child
labour, role of women workers and their working conditions, issues of forced labour,
workers’ rights including right to organize trade unions, right to strike, etc. It further dealt
with issues of minimum wages to workers and their health, safety and working hours.

5.7 TRADE POLICY REVIEW MECHANISM

WTO is based on principles of transparency and non-discrimination. Accordingly, the
policymakers of respective countries as well as the globally engaged business firms
need to know how transparent and fair are the trade policies conditions of the country,
they trade in. Each stakeholder in global trade is interested to know whether the
regulations and policies shaping the operating business environment are fundamentally
transparent. Trade Policy Review Mechanism of WTO helps understand about it.
Procedurally, it is achieved in two ways:
 The respective member states have to inform the WTO and fellow-members
of specific measures, policies or laws through regular “notifications”; and
 WTO secretariat conducts regular reviews of individual countries’ trade
policies, which are known as the trade policy reviews.
With the creation of the WTO in 1995 as the permanent body on issues related to
World Trade, the issues related to services and intellectual property are included in the
ambit of Trade Policy Review (refer once again Exhibit 5). The key objectives of
Trade Policy Review of a country are:
 to increase the transparency and understanding of trade policies and practices
of the member-country through regular monitoring.
 to strengthen and improve the quality of public and intergovernmental debate
on the issues which require attention of member-states on trade distorting policies. 95
International Trade  to understand and comprehend the multilateral assessment of the effects of
policies on the world trading system.
The trade policy reviews are taken in cognizance of the wider economic and
developmental needs of a member-country. It further understands the underlying policy
initiatives and socio-economic objectives, and the external economic environment of
the member-country and its sustainable development requirements. The Trade Policy
Review ensures discipline in global trade order among member countries and encourages
member-states to follow more closely the WTO rules and disciplines. The end outcome
of trade policy review is to ensure the commitments of member-state towards
transparency and non-discriminatory trade architecture. The frequency of the Trade
Policy Reviews depends on the country’s size, for instance:
 The Trade Policy Review takes place once in every two years for four biggest
traders; the European Union, the United States, Japan and China.
 The next 16 countries (in terms of their share of world trade) are reviewed
every four years. India falls into this category.
 The review for remaining countries takes place every six years, with the
possibility of a longer interim period for the least-developed countries.

5.8 INDIA’S EXPERIENCE UNDER WTO TRADE

REGIME
India started economic reforms in 1991 thus transforming the entire business eco-
system of the country by unshackling it from the clutches of inspector raj and centrally
planned model. The process of economic liberalization, privatisation and globalisation
provided Indian industry and service sector to come to terms of engaging with external
world. The technological transfers, foreign investments and managerial know-how helped
Indian business firms to produce and trade cost effectively. These reforms helped
Indian industries and service sector to prepare for the process of globalization which is
shaped with the formation of WTO in 1995.
The resulting integration of the Indian economy with the global economy has given a
thrust to enhanced economic activities, economic growth and expansion, industrial
diversification and increased the standards of living of Indians. India’s exports started
rising, so were the foreign exchange reserves thus giving the confidence to Indian
policy-makers to liberalize the economy in more sectors. Indian economy started
prospering with higher external engagements under the transparent and predictable
trade regime of WTO and per-capita income of India started rising dramatically.
This led to higher consumption, resultantly leading to higher industrial production
and growing imports.
India substantially increased its exports of manufactures and services relative to
traditional commodity exports, as newer sectors of the economy started growing and
competing with the best in the world markets. The growth of service sector, especially
that of Information Technology, has established India among the top 10 players in
global service exports. Liberal investment regime provided India a required cushion
with ever-increasing foreign exchange reserves which have been possible under the
predictable trade regime of WTO. The opening of trade and investment led to plethora
of economic opportunities and has been an important element in the economic success
96
of India, where the average import tariff has fallen from as high as 100% in some WTO Agreements

sector to mere 7.5% percent for majority of national tariffs in the last 30 years. Although,
the series of PTAs/FTAs signed by India have provided mixed economic results, external
economic reforms were not supplemented with internal economic reforms, especially
in the manufacturing sector.
The potential gains from eliminating remaining trade barriers have considerable economic
gains for India under the WTO trade regime. It however cannot make an economic
success similar to that of other economies especially China and other South East Asian
Economies. There is need to boost the competitiveness of domestic sector and it requires
a series of domestic reforms’ both at central and state levels. India can gain even higher
results at global level if internal reforms are pursued with enthusiasm and good spirit.
Overall, India has benefitted under the global trade regime of WTO.
Activity 4
Arrange a meeting with an experienced executive of a company engaged in
international business/trade (if you are presently not working /employed in such a
company). Write a note on how WTO has affected the company (by comparing
the position in pre-WTO and post-WTO periods) in terms of relative advantages
or otherwise.
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5.9 SUMMARY
The WTO, set up in 1995, is the successor to the General Agreement on Tariffs and
Trade (GATT). GATT came into existence in 1948 with the objective of liberalization
of trade. It also provided a forum to countries to discuss and overcome their trade
problems and negotiate to enlarge international trading opportunities.
Eight major trade negotiations took place under GATT auspices but the Uruguay Round
was the most significant which lasted for about 8-years and led to the culmination of
WTO. Its main function is to ensure that trade flows as smoothly, predictably and
freely as possible. At the heart of the system, known as the multilateral trading system,
all WTO’s agreements are negotiated and signed by a large majority of the world’s
trading nations, and ratified in their parliaments.
These agreements are the legal ground rules for international trade. Essentially,
they are contracts, guaranteeing member countries important trade rights. They
also bind governments to keep their trade policies within agreed limits to each
country’s benefit.
Some of the key functions of WTO are:
 Administering trade agreements;
97
International Trade  Acting as a forum for trade negotiations;
 Settling trade disputes and
 Reviewing national trade policies.
WTO has over 164 members, accounting for over 98% of world trade. Decisions are
made by the entire membership through consensus. The WTO’s top level decision
making body is the Ministerial Conference which meets at least once in every two
years. Under this is the General Council (normally ambassadors and heads of
delegations) which meets several times a year in the Geneva headquarters. The General
Council also meets as the Trade Policy Review Body and the Dispute Settlement
Body. At the next level, the Goods Council, Services Council and Intellectual Property
(TRIPS) Council report to the General Council. Numerous specialized committees,
working groups and working parties deal with the individual agreements and other
areas such as the environment, development, membership applications and regional
trade agreements.
The WTO Secretariat, based in Geneva, has around 600 staff and is headed by a
director general. India’s stand on WTO has evolved over the years. Like any developing
nation the outcome of the Uruguay round also was a setback for India. Aspects like
TRIPS were most surprising and disappointing aspect for the developing countries in
the Uruguay Round and India was taken by surprise by the reach of the TRIPS
agreement. One of the main ways that India can gain is through tariff cuts in the
developing country (DC) markets. To really gain from the Uruguay Round, India will
have to be an efficient producer of goods and services, since improved market access
does not benefit India alone, but its competitors as well.

5.10 KEY WORDS

GATT : General Agreement on Tariffs and Trade is a multilateral treaty/
agreement that laid down the rules for conducting international
trade.

Multilateral Trade : Negotiations by a large group of countries in regard to

negotiations trade which leads to mutually agreed multilateral
agreements.

Uruguay Round : The last and the most significant of the GATT round of
negotiations which led to a large number of agenda items for
implementation during 1986 to 1994, and which led to the
formation of WTO.

WTO : World Trade Organization is a multilateral trade body of 164

member countries and its main function is to ensure that trade
flows as smooth, predictable and free as possible.

TRIPS : Trade related intellectual property rights.

TRIMS : Trade related investment measures that necessitate investors

to attain certain standards of performance consistent with
national treatment.
98
 WTO Agreements
5.11 SELF-ASSESSMENT QUESTIONS
1) What is GATT? Discuss the various rounds of trade negotiations under GATT
including its key achievements.
2) What are the key outcomes of the Uruguay Round of GATT negotiations?
3) What necessitated the setting up of WTO? Discuss its aims and objectives.
4) Discuss the framework agreements that establish the World Trade Organization?
5) What are some of the major areas in which WTO has been focusing on? Evaluate
the current stand of the WTO members in relation to the following:
i) Trade in Services
ii) Agriculture
iii) TRIPS
6) Write an essay on India’s experience with WTO trade regime.
7) Critically examine the organizational structure of WTO. What are its key organs?

5.12 REFERENCES/FURTHER READINGS

 Shad Morris, James Oldroyd & Ram Singh (2021): International Business, Wiley
India Pvt. Ltd.
 John D. Daniels, Lee Radebaugh & Daniel P. Sullivan (2018): International
Business, 16th Edition, Pearson Publication.
 Ram Singh (2020): Export- Import Management, Sage Books, 1st Edition, 2020.
 Lee Kiefer and Carter Steven (2012).Global Marketing Management by, Oxford
University Press.
 Charles W.L. Hill, G.Tomas M. Hult & Rohit Mehtani (2018): International
Business: Competing in the Global Marketplace (SIE), 11th Edition.
 MS-97, International Business, School of Management Studies, IGNOU, New
Delhi, November, 2015 (Reprint).

99
International Trade
UNIT 6 REGIONAL TRADE BLOCS
Objectives
After reading this unit, you should be able to:
 explain the types of trade blocs;
 analyze the reasons behind the upsurge in trade blocs in the recent past;
 identify the major trade blocs in the world; and
 brief-up the history of European Union (EU) which is the largest trade bloc.
Structure
6.1 Introduction
6.2 Types of Trade Blocs
6.3 Benefits of Trade Blocs
6.4 Reasons behind the Recent Upsurge in PTAs
6.5 Welfare Impact of PTAs
6.6 Trade Creation and Trade Diversion
6.7 Major Trade Blocs in the World
6.8 European Union (World’s Largest Trade Bloc)
6.9 Summary
6.10 Key Words
6.11 Self-Assessment Questions
6.12 References/Further Readings

6.1 INTRODUCTION
Regional Trading Bloc; popularly known as trading blocs, is a group of countries within
a specified geographical region, which specify the common trade policy vis-à-vis tariff,
non-tariff issues, and other trade issues such as movement of labour and capital among
themselves with an objective of creating Free Trade Area or Customs Union or Common
Market Area or Economic Union. In short, they are a force of economic integration
which increasingly shapes the world trade (www.economicsonline.co.uk). Trade blocs
can be stand-alone agreements among several states. Trade blocs fall into different
categories based on the level of economic integration. These categories are discussed
in subsequent section.
After second world, countries realized the importance of trade not only for economic
development but for promoting peace and prosperity in the region. Free trade initiatives
were taken, particularly in Europe where countries pool their coal resources in order
to help each other and avoid conflicts. This small initiatives result in formation of
European Union after passing through various stages of economic integration. Today,
there is no region in the world that does not have free trade agreements or other
initiatives for free trade and commerce. Various stages of economic integration have
100
been evolved namely preferential trade, free trade, custom union, common market and Regional Trade Blocs
economic union. Free Trade encourages labour force specialization and also help
countries specialize in the areas of their factor endowments. In other words, free trade
allows a country to produce and export what it does best and most efficiently, while
allowing it to import specialized goods from other countries. Thus, Free trade helps
both sides to save costs while gaining superior products through the exchange of goods
and services. Regional Trade Agreements have many other benefits which can be
diagrammatically (Figure 6.1) understood as under:

Improved Standard of Living Through Superior Goods At Lower Prices

Competition Induces Innovation

BENEFITS OF Free Trade provides incentives for countries to be at peace with each
FREE TRADE other

Economic Freedom offer more employment opportunties

Harmonised Law/Rules promotes Transperency and reduces red-tape

Figure 6.1 : Benefits of Regional Trade Agreements

Since the 1980’s, the trade blocs have spread throughout the world economy under
the harmonized and liberalized economic regime shaped under the 8th round of Uruguay
Round of Trade negotiations and subsequently under the ambit of WTO. Compared
to 7trade blocs that were notified to GATT/WTO in 1980, at the end of 2021, there
were 586 trade blocs. Their number has increased significantly after the formation of
WTO, as nation’s increasingly realized the merits of foreign trade, providing a catalysing
force for economic growth and development.
These statistics show the importance of trading blocs in the present world economy,
and provide a motivation to examine them in great detail, which is taken up in this
unit.

6.2 TYPES OF TRADE BLOCS

There are various types of trade blocs. These are:
 Preferential Trading Arrangements (PTAs)
 Free Trade Agreement (FTA)
 Customs Markets
 Common Markets
 Economic Union
 Political Union
Preferential Trading Arrangements (PTAs): It is a kind of trading bloc that gives
preferential access on certain products to the member countries. It can be established
through a trade pact and is the first stage of economic integration. The tariffs and non-
tariff barriers are reduced only on a part of all traded goods. The PTAs are advanced
to next stage of economic integration that is Free Trade Area.
101
International Trade Further, the Exhibit 6.1 as under describes the levels of economic integration in various
types of regional economic groupings.
Exhibit 6.1: Levels of Economic Integration in Regional Economic Groupings
Level of Preferential No Common No Harmonized/ Unified
Integration Duty Tariff External Restrictions Unified Economic
Regime and Tariffs and on Economic & Political
Non- Harmonized Movements Policies & Policies &
Tariff NTB of Labor & Institutions Institutions
Barriers Capital

Preferential Trade Yes No No No No No

Agreement

Free Trade Area Yes Yes No No No No

Custom Union Yes Yes Yes No No No

Common Market Yes Yes Yes Yes No No

Economic Union Yes Yes Yes Yes Yes No

Political Union Yes Yes Yes Yes Yes Yes

Source: World Trade Organization.

Free Trade Area/Agreement (FTA): In a FTA, all tariffs and non-tariff barriers are
removed exception being some items in the negative list which is mutually agreed among
member states. Examples of FTAs are the NAFTA (North American Free Trade
Agreement) and India-Sri Lanka Free Trade Agreement. Rules of Origin (RoO) are
framed which specifies the conduct and criteria of value-addition under a FTA. Rules
of Origin provide protection against malpractices used by firms beyond the member
states to export goods at lower rates of duties. For example, when India and the Sri
Lanka are FTA partners and offer 0% duties to each other subject to fulfilment of
Rules of Origin criteria. Sri Lanka in turn may have a FTA with another country, let us
hypothetically assume, it is China. Chinese firms will export their goods at zero duty
first to Sri Lanka and such goods do have a probability to enter India under India-Sri
Lanka FTA. But, Rules of Origin will ensure that such goods cannot enter Indian
Territory without fulfilling the criteria as mandated under Rules of Origin.
Customs Union (CU): In a customs union, external tariffs are harmonized among
member states for the goods originating from the non-member countries. Thus, a CU
has a common external tariff (CET) against non-members states. Because the tariff is
the same for all member countries, rules of origin are not required to prevent “backdoor”
imports from non-member countries. South African Customs Union i.e. SACU (a
regional economic grouping among countries such as South Africa, Namibia,
Mozambique, Botswana and Eswatini, erstwhile Swaziland), is an example of customs
union.
Common Market: A common market have all features of a Customs Union, i.e.
elimination of tariff and non-tariff barriers plus common external tariff and also have
provisions for free movement of labour and capital within the regional economic grouping.
Central American Common market consisting of Costa Rica, El Salvador, Guatemala,
Honduras and Nicaragua, is an example of Common Market.
Economic Union: An economic union is a common market coupled with harmonized
102 and unified economic policies which are coordinated among the member countries.
Economic Union have common trade policies, common external tariffs, free movement Regional Trade Blocs
of labour and capital and common banking and monetary policies. For example, in an
economic union, countries, normally, have a common monetary and fiscal policy and a
common currency. The purpose of the Maastricht Treaty was to move the European
Community (EC) from a customs union to an economic union, with a common currency
(the Euro) and central bank (the European Central Bank).There can be a monetary
union with an economic union, for example Euro Zone countries having a common
currency, EURO with European Union which is an Economic Union. Monetary Union
is a case when two or more member states have common currency thus leading to
formation of a Monetary Union.
Political Union: Political Union is the highest stage of levels of economic integration in
a regional economic grouping. In addition to economic union, Political Union envisages
the harmonization of system of political governance, i.e. single government, one
president, one foreign policy, one defence policy among the member states. In nutshell,
the member countries of an economic union decide to become a one country.
PTAs, FTAs, Customs Unions and Economic Union are termed as Regional Trade
Agreements in the terminology of WTO. Henceforth; we will use the term RTA as a
broader term to discuss various aspects of trade blocs.

6.3 BENEFITS OF TRADE BLOCS

Following are the benefits (Figure 6.2) of Regional Trade Blocs.
 Increased Production & Better Economies of Scale: Free Trade/Regional
Trade Agreements enable participating countries to specialize in the production
of those commodities in which they have a comparative advantage or factor
endowment. Increased specialization in areas of core competency enables
countries to take advantage of efficiencies generated from economies of scale
and scope, higher productivity and increased output.

Benefits of Regional Trade Blocs

Improvements in Greater Production Improved Economic Increased Production &

Employment Scenario Efficiencies Growth Better Economies of Scale

Figure 6.2 : Benefits of Regional Trade Blocs

 Greater Production Efficiencies: Free Trade Agreements help an effective

division of resources and improve the efficiency of resource allocation. Effective
and efficient resources allocation results in higher productivity and increasing
total domestic output of goods and services. Firms from the participating
countries compete for market share leading to innovative production
techniques, use of new technology, better management practices and marketing
skills and cost effective distribution and transportation methods.
 Improvements in Employment Scenario: Free Trade Agreements create
more business opportunities and investors throng to such cost competitive
areas of business. This leads to improvements in employment scenario in
exporting industries. For example, with liberalized trade regime in services
sector, India has created 4 million direct jobs in software and IT enabled
industry. 103
International Trade  Improved Economic Growth: Regional Trade/Free Trade Agreements
improve the overall business environment due to spill over effects resulting in
higher standard of living, higher wages leading to increased real incomes and
improved economic growth due to increased consumers spending.

6.4 REASONS BEHIND THE RECENT UPSURGE IN

PTAs
The principle of non-discrimination is central to the formation of the GATT Agreement,
which is signed on 30 October 1947 by representatives from 23 countries in Geneva.
Article I embodies the strong support for non-discrimination, requiring Most-Favoured-
Nation (MFN) status for all GATT members. The only significant exception to MFN is
to be found in Article XXIV, which allows formation of Regional Trade Grouping with
the objectives of promoting and facilitating free trade and acting as a ladder to formation
of globalized world order under transparent and non-discriminatory trade regime. In
principle, Article 24 allows members to reach ‘interim’ agreements so that they can
offer preferential treatment prior to the implementation of a full agreement.
The first wave of ‘regionalism’ attempted in the 1960s failed mostly because the USA,
the most powerful nation in the GATT and the chief proponent of multilateralism and
non-discrimination in global trade order, was against it. The continuous rounds of trade
talks led to mutual agreement among member states and led to more harmonized and
standardized trade policies, initially under GATT and subsequently under the World
Trade Organization. The various trade agreements under the mandate of WTO provide
a platform of enhanced trade among member states. These agreements are futuristic,
aimed at creating a peaceful world order, ensuring the participation of all, rich and
poor with Special and Differential Clauses for treatment. The spirit of these trade
agreements is aimed at promoting world trade by all means including leveraging the
regional trade agreements among member states.
Activity 1
What are the various Regional Trade Blocs to which, India has membership?
Discuss three most prominent Regional or Bilateral Trade Agreements signed by
India.
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6.5 WELFARE IMPACT OF PTAs

The resurgence of PTAs has led to renewed interest as to how PTAs have an impact
on the welfare. Conceptually, they have four general economic effects. These are
discussed as follows:
i) Income gains from greater specialization of resources and greater opportunities
for exchange within the region. These are called the static gains from regional
104
 integration. The static gains from trade are the result of the elimination of the Regional Trade Blocs
dead weight losses due to tariffs and non-tariff barriers being removed. There
are the two kinds of gains; first the enhanced exchange of goods and services,
and second the enhanced specialization in the industry or work-function which
originates from the removal of trade barriers.
ii) Additional, there are growth opportunities in the long-run especially from the
economies of scale and scope, improved competitiveness of firms,
improvements in technology and inward foreign direct investment inflows.
These are called the dynamic gains from regional integration. The dynamic
gains are expected to be much larger than the static gains from trade.
iii) Transitional costs that fall in the short-run on inefficient sectors and immobile
factors, as firms rationalize and reallocate their activities throughout the region.
When prices of a regional partner are lower than those at home, opening-up
to free trade means that demand for products of the domestic industry will
fall. There can be industrial sickness resulting in exit of certain business firms
as the consumers switch-over and buy cheaper imported goods from the
PTA partner country. As firms exit or downsize leading to lay-off workers,
the workers willing to relocate find jobs quickly with the increasing business
opportunities in a RTA. Those not willing to relocate, however, may never
regain full time employment.
Thus; the free trade has transitional costs. The cost of goods and services fall
first before the accruing of prospective potential static and dynamic trade
gains. Economists express it as “short-term pain for long-term gain”.
iv) Greater economic interdependence within the region, due to the inter-linkages
created by trade and investment flows. Such economic interdependence creates
sensitivity and vulnerability to instabilities in a trading partner but also offers
potential additional gains from the multiplier effects of linkages with a faster
growing partner. For example, if the Mexican economy is more closely tied
and linked to the US economy, the more Mexico will benefit from the much
stronger US economy. Conversely, a currency crisis in Mexico will have
substantial impact on US exports to Mexico.
The welfare impacts are expected to be particularly large for small countries (note that
“small” means small in terms of the world market for a particular product so a country
could be small in one market and large in others at the same time) because they are
price-takers in world markets. These impacts are both positive and negative, but the
gains are expected to be much larger than the losses.
Small countries gain from regional economic integration:
 Removal of their own tariffs and NTBs on imports from the larger country —
As price-takers, small countries cannot affect the world price and so their
own tariffs and NTBs are simply reflected in their own (higher) domestic
prices, causing deadweight losses to national welfare. When the small country
removes its own tariffs, this creates real gains in national welfare for itself.
 Removal of the larger member country’s tariffs and NTBs against the small
country’s exports — As price-takers, small countries cannot affect the world
price so that a tariff levied by a large country falls mostly or wholly on the
105
International Trade small country. This means that from small country exporters receive “LESS”
for their products in world markets. When the large country takes off its tariff,
this is a real gain for the small country.
 Gains from economies of scale and scope are likely to be very important for
small countries that join a RTA as it gains access to a much larger market. For
example, Canada joining the Canada-US FTA gained access to the 10-times
larger US market; the economies of scale from access to the larger US market
were expected to be the primary source of gains to Canada from joining the
agreement.
On the counter-arguments, some experts say that small countries lose from
regional economic integration:
 The larger gains for small countries imply larger transition costs also; and
further
 Small countries are more vulnerable once they join a PTA with a large country
since they have to adjust to changes with a system as present in the large
country.

6.6 TRADE CREATION AND TRADE DIVERSION

Let us examine the static gains from regional integration more carefully. First, the
economic welfare impacts of a PTA can be mixed; that is, it is NOT ALWAYS TRUE
that global welfare or even welfare for a member country improves as a result of a
PTA.
The impacts depend upon the following:
 Trade creation occurs when production is shifted from higher cost producers
to lower cost producers within the trading bloc. When the trade barriers are
eliminated among PTA members, differences in comparative costs will lead to
shifts in trade, production and investment patterns. According to the law of
comparative advantage, production should shift to the lower cost producers
and this would improve economic efficiency within the PTA.
 Trade diversion occurs when production is shifted to higher cost internal
producers from lower cost external producers. This is because the products
of the external producers have become uncompetitive in the internal market
due to the creation of the preferential trading area. Before the PTA both inside
and outside countries faced the same tariff barriers. Once the PTA is formed
only the outside countries face the tariff barriers. Removal of the tariff barriers
against the inside countries may give them a competitive advantage that diverts
trade and production away from the most efficient producers (the outsiders)
towards the less efficient. Thus the PTA creates inefficiencies since trade is
not with the overall lowest cost producer.
If trade creation outweighs trade diversion, economists normally argue that world welfare
will improve as a result of an FTA (that is, the static gains are, on net, positive). If trade
diversion dominates, welfare falls. It might be helpful to illustrate the concepts of trade
diversion and trade creation with an example. Assume we have three countries: Chile,
France and Germany producing and consuming apples. Assume that Chilean apples
106 cost 50 cents each, French apples are 60 cents, and German apples are 70 cents. If
there are no national tariffs, Chilean producers are the most efficient apple producers Regional Trade Blocs
and the law of comparative advantage predicts that Chile will produce and export
apples to France and Germany. The world price of apples would be 50 cents.
Suppose Germany levies a 15-cent specific tariff on all apple imports in order to protect
its domestic industry. Then Chilean apples in Germany cost 50+15 = 65 cents, and
French apples in Germany cost 60 + 15 = 75 cents. Since German apples cost 70
cents, German consumers continue to import Chilean apples at a price of 65 cents (i.e.
the tariff has reduced, but not eliminated, trade) between Germany and Chile. French
apples are not imported.
Now let us compare two cases:
 Case #1: Germany and Chile form a Customs Union
If Germany and Chile form a CU and remove tariffs between them, then
Chilean apples now cost 50 cents in Germany (since there is no tariff) while
the price of French apples remains at 75 cents (since French producers must
still pay the German tariff). German consumers buy Chilean apples, and the
price of apples returns to 50 cents. Trade creation has occurred since the
PTA generates trade with a more efficient producer. Trade creation increases
world welfare, unambiguously.
 Case #2: Germany and France form a Customs Union
If Germany and France form a CU and remove tariffs between them, then
French apples now cost 60 cents in Germany (since there is no tariff) while
the price of Chilean apples remains at 65 cents (since Chilean producers must
still pay the German tariff). German consumers buy French apples, and the
price of apples moves to 60 cents. Trade diversion has occurred since the
PTA generates trade with the less efficient producer, i.e., France. Trade diversion
may reduce world welfare.

6.7 MAJOR TRADE BLOCS IN THE WORLD

Let us now discuss some of the major trade blocs in the world.
United States-Mexico-Canada Agreement (USMCA): USMCA came into force
on July 1st, 2020 and was earlier known as North America Free Trade Agreement
(NAFTA). NAFTA was formed on January 1, 1994 and it brought immediate elimination
of tariffs on more than one half of U.S. imports from Mexico and more than one third
of U.S. exports to Mexico. NAFTA was the largest regional economic grouping of the
world and it is now replaced with USMCA. USMCA commits all parties to end
restrictions on member-countries for trade and investment policies. Foreign investors
are provided a high level of protection of intellectual property, liberalized trade in services
and there are agreements on environmental and labour standards. The US has, for
long, been demanding the reworking of provisions of trade agreements as it benefits its
trade partners much more than itself. In order to correct the trade imbalances and to
offer more beneficial trade terms for North American workers, farmers, ranchers, and
businesses, NAFTA was re-negotiated, paving the way for a progressive and futuristic
trade agreement called USMCA. USMCA Agreement creates more balanced,
reciprocal and trade supporting provision that facilitates the high-paying jobs for
Americans and growth opportunities to the entire North American economy. 107
International Trade Association of South East Asian Nations (ASEAN): It was formed in 1967 but
started making progress only in 1970s. Its members are Brunei, Indonesia, Laos,
Malaysia, Myanmar, Philippines, Singapore, Thailand and Vietnam. It has started
through partial liberalization of trade in select range of products. The other important
step was to identify several regional projects, which would cater to the requirements of
all the member countries. Each country will have one regional project. It is one of the
most successful regional economic groupings after European Union and has been
successful to achieve its objectives as laid down at the times of its foundation. The
basis of ASEAN success is its emphasis on three principles of cooperation; these are
security and socio-cultural and economic integration among member states.

Security

Pillars of
ASEAN’
Countries
Success
Economic Socio-Cultural
Integration Integration

Source: ASEAN Secretariat, Jakarta, Indonesia.

Figure 6.3 : Pillars of ASEAN’ Countries Success

ASEAN has made noteworthy progress in economic integration and created an

ASEAN Economic Community (AEC) by the year 2015. ASEAN Economic
Community have combined total population of over 560 million people and a gross
domestic product of over $3.2 trillion. Its GDP is further likely to reach to almost $ 5
trillion by 2027.
Asia-Pacific Economic Cooperation (APEC): Formed in 1989 as an informal
dialogue group with limited participation, APEC has become a forum for negotiations
to achieve the goal of free trade and investment in the Asia-Pacific region. APEC has
18 members– Australia, Brunei, Canada, Chile, China, Hong Kong, Indonesia, Japan,
South Korea, Malaysia, Mexico, New Zealand, Papua New Guinea, Philippines,
Singapore, Taiwan, Thailand and USA. This is though the most sweeping trade
agreement in history, committing half the world economy to eliminate all barriers among
themselves, but has limited success in practical terms.
Some other regional trade blocs are briefly described below:
Andean Community: The Andean Community is a trade bloc comprising the South
American countries of Bolivia, Colombia, Ecuador and Peru. The trade bloc was
called the Andean Pact until 1996 and came into existence with the signing of the
Cartagena Agreement in 1969. Its headquarters are located in Lima, Peru.
SAPTA: South Asian Preferential Trading Arrangement (SAPTA) is an intra-regional
trade agreement of the SAARC countries— India, Pakistan, Sri Lanka, Bangladesh,
Nepal, Bhutan, Afghanistan and the Maldives.
108
SACU: The Southern African Customs Union (SACU) consists of five Member Regional Trade Blocs
States— Botswana, Lesotho, Namibia, South Africa and Swaziland. It was established
through the Customs Union Agreement of 1910.
GCC Countries: Gulf Cooperation Council is a trade bloc involving six Arabic states;
these are— Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates.
Activity 2
India’s first FTA was signed with Sri Lanka. Evaluate some of the gains that both
the countries have gained from this FTA? Corroborate your answer with some
industry examples.
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6.8 EUROPEAN UNION (WORLD’S LARGEST

TRADE BLOC)
History: The roots of EU go back to the Second World War. Europe was split into
East and West Europe after the world war resulting in a 40 year old long cold war.
1949: The council of Europe is created by West European nations.
18th April 1951: Six nations namely, Germany, France, Italy, the Netherlands, Belgium
and Luxemburg join hands to sign a treaty (Coals & Steel Treaty ) to run their heavy
industries.
25th March 1957: Witnessing the success of Coals & Steel Treaty, the 6 nations
expand cooperation to other economic sectors by signing the Treaty of Rome resulting
in creation of European Economic Community (EEC).
30th July 1962: The EU starts its ‘common agricultural policy’ giving the countries
joint control of food production.
20th July 1963: EU signs first big international agreement, a deal to help 18 former
colonies in Africa.
1st July 1968: The 6 nations remove customs duties on goods imported from each
other, allowing for the first time free cross-border trade.
1st July 1968: The 6 nations remove custom duties on goods allowing free cross-
border trade; world’s biggest trading group is born.
24th April 1972: The Exchange Rate Mechanism (ERM) created, which was the first
step towards the introduction of Euro, 30 years later.
24th April 1972: An Exchange Rate Mechanism (ERM) is developed wherein members
allow their currencies to fluctuate against each other within limits. This forms the
foundation of Euro.
109
International Trade 1st January 1973: Denmark, Ireland and UK formally enter EU and the count
increases from six to nine nations.
10th December 1974: EU leaders set up the European Regional Development Fund
with a purpose to use the money for poor regions.
7-10th June 1979: EU citizen directly elect the members of European Parliament for
the first time.
1st January 1981: Greece joins EU making the count to 10.
28th February 1984: EU adopts ‘Esprit’ programme as the first research and
development programme to be fund.
17th February 1986: Single European launches a 6 year programme to sort out the
difference in national regulations.
7th February 1992: Maastricht Treaty signed and is considered to be a major EU
milestone. ‘European Community’ is officially replaced by ‘European Union’.
1st January 1993: Single market and its four freedoms are established. Four freedoms
are the free movement of goods, services, people and money.
1st January 1995: Austria, Finland and Sweden join the EU.
26th March 1995: The Schengen Agreement takes effect in seven countries.
17th June 1997: Signature of the Treaty of Amsterdam built on the achievements of
Maastricht treaty.
13th December 1997: The process of membership negotiations with 10 countries of
Central and Eastern Europe starts.
1st January 1999: Euro is introduced in 11 countries for commercial and financial
transactions.
29th October 2004: 25 EU countries sign a treaty establishing a European constitution.
2007: Bulgaria and Romania join the EU.
1st July 2013: Croatia joins EU.
31 January 2020: UK left the European Union in compliance to a referendum
conducted in 2016 for this effect.
Overall, The EU is the most successful regional economic grouping of the world. In the
future, it has to deal with challenges arising-out of slowing down of economic activities
due to Covid-19 pandemic, ageing population and internal bickering within the group.
Europe is facing security threat which is making it vulnerable economically and geo-
strategically.
Activity 3
Open the European Union website (www.europa.eu.) and describe the future
challenges the EU is facing with.
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6.9 SUMMARY
A trade bloc is a Free Trade Area in which tariffs are not imposed among members,
but members keep their own external tariffs against non-members. Trade blocs have
become quite popular and account for over half of the World Trade. Trade Pacts
signed as a result of creation of such trade blocs have their own grievances settlement
mechanism.
There are six kinds of trade blocs, namely Regional Trade Blocs.
1) Preferential Trading Arrangement (PTA): Trading bloc which gives
preference to certain products from member countries.
2) Free Trade Area (FTA): In a FTA, the tariffs and non-tariff barriers are
removed for the member countries except the few items listed in the negative
list which is mutually agreed among member states.
3) Customs Union (CU): In a customs union, there is a common external tariff
for non-member states in addition to all features of FTA, i.e. abolition of tariff
and non-tariff barriers among member countries.
4) Common Market: A common market has the free movement of labour and
capital in addition to abolition of all tariff and non-tariff barriers and having a
common external tariff for non-member states.
5) Economic Union: An economic union has complete harmonization of trade,
investment, banking and monetary policies. It is the highest stage of an
economic integration.
6) Monetary Union: An arrangement where two or more countries share the
same currency.
7) Political Union: Political union is even a step ahead of economic union wherein
there is one system of political governance in addition to harmonized economic
governance under Economic Union as discussed above.
There are over 586 trade blocs operating as on December 2021. Some of the trade
blocs like European Union have developed even common currency besides common
operating parliaments and trading systems.
The major trading blocs of the world are United States-Mexico-Canada (USMCA),
earlier known as NAFTA, Association of South East Asian Nations (ASEAN), Asia-
Pacific Economic Co-operation (APEC).
Regionalism leads to specialization of resources and is accepted under WTO rules as
it ultimately leads to globalization, the central objective of rules of WTO. There is a
greater competitiveness, trade and investment flow, and regional inter-linkages with
greater scope to reallocate activities within the region.
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International Trade Small countries tend to gain more from regional trade and regional integration as a
result of trade creation and trade diversion. Regional integration in Western Europe
was initiated with the creation of European Economic Commission (EEC). In 1991,
Treaty of European Union (the Maastricht Treaty) was signed by European Commission;
the Council of Ministers changed the name to European Union. This led to creation of
Economic and Monetary Union (EMU) – with a single currency (Euro). Four bodies
govern the European Community: European Council of Ministers, European
Commission, European Parliament, and European Court of Justice. In addition to these
four organizations, European Central Bank (ECB) has also been added.

6.10 KEY WORDS

Free Trade Agreement (FTA) : It refers to Free Trade Area, i.e. abolition of
tariff and non-tariff barriers among member-
states.
Customs Union : It refers to common external tariff for non-
member states of agreed FTA members.
Common Market : Common Markets ensure free movement of
labour and capital in addition to all features
of a Custom Union.
Economic Union : The highest level of economic integration;
wherein member states have common trade,
investment and banking policies.
Political Union : A Political union is utopian state of economic
integration wherein member states have one
system of political governance, i.e. single
president, single parliament and single law, etc.
Preferential Trade : Preferential trade refers to offering tariff
preference to member states; it is the first stage
of an economic integration.
ASEAN : A trade agreement of the South East Asian
countries comprising Brunei, Indonesia, Laos,
Malaysia, Myanmar, Philippines, Singapore,
Thailand and Vietnam.
USMCA : USMCA, the world’s largest free trade area,
is an association of the three countries: the
U.S.A., Canada and Mexico.
MERCOSUR : It is a Regional Trade Agreement (RTA)
among Brazil, Argentina, Uruguay and
Paraguay, founded in 1991.
Rules of Origin : These rules may be called the rules of
determination of Origin of goods under the
Free Trade Agreement.
APEC : It is a forum for negotiations to achieve the
112 goal of free trade and investment in the Asia-
 Pacific region and its members are Australia, Regional Trade Blocs
Brunei, Canada, Chile, China, Hong Kong,
Indonesia, Japan, South Korea, Malaysia,
Mexico, New Zealand, Papua New Guinea,
Philippines, Singapore, Taiwan, Thailand and
USA.
European Union (EU) : An economic union where the countries have
a common currency, common markets and
unified EU parliament to govern the matters
of the Union.

6.11 SELF-ASSESSMENT QUESTIONS

1) What are the different types of trading blocs? What distinguishes them? Explain.
2) Compare Customs Union with Common Market and bring out clearly the
differences.
3) Explain the concepts of trade creation and trade diversion in detail, giving examples.
4) Why have trading blocs become so popular lately?
5) Write a short note on the European Union.

6.12 REFERENCES/FURTHER READINGS

 Shad Morris, James Oldroyd & Ram Singh (2021): International Business, Wiley
India Pvt. Ltd.
 John D. Daniels, Lee Radebaugh & Daniel P. Sullivan (2018): International
Business, 16th Edition, Pearson Publication.
 Ram Singh (2020): Export- Import Management, Sage Books, 1st Edition, 2020.
 Lee Kiefer and Carter Steven (2012).Global Marketing Management, Oxford
University Press.
 Charles W. L. Hill, G. Tomas M. Hult & Rohit Mehtani (2018): International
Business: Competing in the Global Marketplace (SIE), 11th Edition.
 MS-97, International Business, School of Management Studies, IGNOU, New
Delhi, November, 2015 (Reprint).

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