METHODS OF CORRECTING DISEQUILIBRIUM IN B.O.P.

When such a situation of disequilibrium arises, the following measures are usually adopted.

i) Use of past reserves 

ii) Borrowings from IMF 

iii) Monetary and fiscal policy measures 

iv) Exchange rate adjustments. 

Let us learn them in detail. 

Use of Past reserves: A country may make use of past reserves to finance the BOP deficit provided such reserves are available. Such reserves consist of gold, foreign currencies and fund related assets i.e., reserve position with the IMF and holdings of special drawing rights. In recent years, increase in quotas and additional allocations of SDRs and expanded private capital flows have contributed to an overall increase in national reserves of several countries. 

Borrowing from IMF: Countries with disequilibrium in B.O.P. Can make use of IMF facilities. These are: 

1. Stand by loans 

2. Extended Fund Facilities (EFF) 

3. Structure Adjustment Facilities (SAF) 

4. Enlarged Structural Adjustment Facilities (ESAF) 

5. Compensatory and Contingency Financing Facilities (CCFF) 

6. Systemic Transformation Facilities (STF).

Monetary and fiscal policy measures: Monetary and fiscal policies are also important tools for influencing B.O.P. Conditions. A change in money supply brought about either through fiscal or monetary policies can bring about the required change in the level of total demand, which includes demand for imported goods and services. 

Exchange rate adjustments; Adjustments in exchange rate is an effective tool. A down- ward adjustment in exchange rate will make exports cheaper and imports dearer. In other words, as a result of such a policy, exports will be encouraged and imports will be discouraged and equilibrium will be restored. 

All these methods, however, suffer from certain limitations. Hence, managing a state of disequilibrium in B.O.P. continues to be a major problem which every country faces. The major problem is that a policy initiative taken for the sake of achieving equilibrium in B.O.P. comes into conflict with other, rather more endearing objectives, such as, economic growth, employment and price stability. Reconciling such conflicts continues to worry policy makers.

FACTORS AFFECTING BALANCE OF' PAYMENTS

The Current Account

A country's current account balance can significantly affect its economy; therefore, it is important to identify the factors that influence it. The most important factors are: 

I) Inflation 

ii) National Income 

iii) Government Restructures 

iv) Exchange Rates. 

Let us discuss them one by one. 

Inflation: If a country's inflation rate increases relative to the countries with which it trades, its current account would be expected to decrease. Due to higher prices at home, consumers and corporations with in the country will most likely purchase more goods overseas (due to high local inflation), while tile country's exports to other countries will decline. 

National Income: If a country's national income rises by a higher percentage than those of other countries, its current account is expected to decrease, other things being equal. As the real income level (adjusted for inflation) rises, so does consumption of goods. A percentage of that increase in consumption will most likely reflect an increased demand for foreign goods.

Government Restrictions: If a country's government imposes a tax on imported goods (often referred to as a tariff) the prices of foreign goods to consumers effectively increases. An increase in prices of imported goods relative to goods produced at home will discourage imports and is expected to increase the current account balance. In addition to tariffs, a government may reduce its imports by enforcing a quota, or a maximum limit on imports. 

Exchange Rates: Each country's currency is valued in terms of other currencies through the use of exchange rates, so that currencies can be exchanged to facilitate international transactions, The values of most currencies can fluctuate over time because of market and government forces, If a country’s current account balance decreases, other things being equal, goods exported by the country will become more expensive to the importing countries, if its currency strengthens, as a consequence, the demand for such goods will decline. For example, a refrigerator selling in the United State for $ 100 require a payment of Rs. 3500, if the dollar were worth Rs. 351- Ks. 1 = $0.028). Yet, if the dollar were worth Rs. 40/- (Rs. 1 = $ 0.025), it would take Rs, 4000 to buy the refrigerator. Which could discourage Indians to buy it, However, according to J-curve theory; a country's trade deficit worsens just after its currency depreciates because price effects will dominate the effect on volume of imports in the short run. That is the higher costs of imports will more than offset the reduced volume of imports. Thus, the J curve theory states that a decline in the value of home currency should be followed by a temporary worsening in the trade deficit before its longer term improvement.

The Capital Account

As with the current flows, government policies affect the capital account as well. A country's government could, for example, impose a special tax on income account by local investors who invested in foreign markets. A tax would discourage people from sending their funds for investment in the foreign markets and could therefore, increase the country's capital account. Capital flows are also influenced by capital controls of various types. Interest rates also affect the capital flows. A hike in interest rates relative to other countries may affect capital inflows from abroad. Similarly, a reduction in domestic rates may induce people to invest abroad. ' 

The anticipated exchange rate movements by investors in securities can affect the capital account. If a home currency is expected to strengthen, foreign investors may be willing to invest in the country’s securities to benefit from the currency movement. Conversely, a country's capital account balance is expected to decrease, if its home currency is expected to weaken, other things being equal. 

When attempting to assess why a country’s capital account changed and how it will change in future, all factors must be considered simultaneously. A particular country may experience a reduction in capital account even when its interest rates are attractive, if the home currency is expected to depreciate.

BALANCE OF PAYMENT DISEQUILIBRIUM

A nation's balance of payment is said to be in equilibrium when it is neither drawing upon its international reserves to make excess payments nor accumulating such reserves as a result of its receipts. In other words, when a country is not able to pay for its imports of goods and services from its export earnings, on accumulating reserves year after year, disequilibrium in balance of payments sets in. Policy initiatives are needed to restore equilibrium.

Disequilibrium in balance of payment may be short term or long term in nature. Short term disequilibrium, arises largely on account of cyclical factors. A crop failure leading to a sudden fall in export earnings may create a shortfall and consequently disequilibrium. 

Long term or structural disequilibrium arises on account of long term structural changes in the economy. Fall in demand of export products due to technological changes may bring about a decline in export proceeds. Decline in demand and prices for natural rubber on account of development of synthetics may be cited as an example. Such a situation call is remedied only by diversification of economy.

DEFICIT AND SURPLUS IN BALANCE OF PAYMENTS

You have learnt that BOP accounting is based on the principles of double entry book- keeping, meaning thereby that for every credit entry, there is a debit entry. Thus, a BOP account always balances. The difference between aggregate debit and credits is called balance. In case, debits exceed credit, balance is negative or deficit, when the credits exceed debits, the balance is positive or surplus. Obviously, the term, deficits or surplus cannot then refer to the entire BOP but sub set of accounts included in BOP. 

Where value of exports exceeds imports, the situation is referred as trade surplus or surplus on trade account. Excess of imports over exports results in trade deficit on trade account. 

The transactions appearing in a balance of payments can be classified in two categories, via autonomous transactions and accommodating or financing transactions, Autonomous transactions take place on their own, in response to their felt needs and are independent of situation in the balance of payments. Accommodating or financing transactions refer to the flows which take place in response to surplus or deficit in the balance of payments. For example, a country may incur or raise its liabilities or reduce its assets in order to pay for the deficit. A deficit in balance of payment exists when payments for autonomous or self motivated transactions exceed receipts. In case, there is a deficit or surplus, there have to be some compensatory transactions to balance the imbalance.

Autonomous and financing transactions are also referred to as above the line ad below the line respectively. 

There are several concepts of ‘balance’ in balance of payments. These are: 

Trade Balance: This is the balance on the merchandise trade account, i.e. Item 1 in the current account. 

Balance on goods and services: This is the balance between the export and import of goods and services. It is the net balance on item I and sub-items 1-6 of item III taken together. 

Current Account balance: This is the net balance on the entire current account items I+ll+IlI. When it is negative we have a current account deficit, when positive, a current account surplus. 

Balance on current account and long term capital: This is also called basic balance. This is supposed to indicate the long term trends in BOP. 

While changes in reserve assets are accurately measured, recording of other items is subject to errors arising out of data inadequacies, discrepancies of valuation and timing, erroneous reporting etc. These are reconciled through a fictitious head of account called 'Errors and Omissions'.

The capital Account & Other Accounts

The capital Account 

The account records the changes in the levels of international financial assets and liabilities. The various classifications within the capital account are private, banking and official. Distinction is also made between short term and long term capital flaws, loans with original maturity of more than one year are classified as long term flows. Long term foreign investment measures all capital investments made between countries, including both direct foreign investment and purchases of securities with maturities exceeding one year. Short term foreign investment measures flows of funds invested in securities with maturities of less than one year. Because of the short maturity, investors of such securities will often maintain their funds in a given country for only a short time, causing short term investment flows to be quite volatile over time.

 Private-capital Flows:

These flows consist of several types of transactions. Among them are: long term loans received by individuals and companies (other than banking institutions), investment by foreigners in the joint stock companies in India, repayment of long term loans by non- resident, obtained from residents, repatriation of Indian investments abroad, deposits in non-resident (external) rupee accounts and in foreign currency non-resident accounts. Capital outflows (debit entries) comprise investments by residents in shares and other financial assets abroad, repayment of foreign loans by residents, repatriation of foreign investments in India, long term loans made to non-residents and so forth. 

Short term capital flows on private account consists of short term borrowings and investments.

Banking Capital Flows:

Capital movements in banking sector covers changes in foreign assets and liabilities of commercial banks, whether privately owned or government owned and cooperative banks. Assets consist of balances held by banks with their foreign branches or correspondent banks abroad, and rupee assets representing loans granted by Indian banks to branches of foreign banks in India and correspondent banks. Liabilities consist of Indian banks' debit balances in their foreign accounts and credit balances held by nonresident banks and few other institutions with banks in India. Any increase in assets (or decrease in liabilities) will be a debit entry while a decrease in assets (or increase in liability) a credit. 

Official Capital flows: 

This category covers transactions affecting foreign financial assets and liabilities of the government of India and the Reserve Bank of India, excluding transactions relating to official reserve assets. Government of India's purchase and repurchase from the IMF are shown in a separate account. Loans received by the Government of India from foreign governments and international institutions are treated as credit entries and amortization or repayment of such loans as debit. 

Look at Table 3.2 which shows India’s balance of payments on Current Account and capital Account in recent years.

The Other Accounts
The remaining accounts in India’s BOP are set out in table 3.4.

The IMF account contains, as mentioned above, purchases (credits) and repurchases from the IMF. SDRs (Special Drawing Rights) are a reserve asset created by the JMF and allocated to member countries from time to time. Subject to IMF regulations, SDRs can be used to settle international payments between monetary authorities of member countries. .An allocation is a credit and the utilization is a debit. The reserves and Monetary Gold account increases (debits) and decreases (credits) in reserve assets. Reserve assets consist of RBI holdings of gold and foreign exchange (in the form of balances with foreign central banks and investments in foreign government’s securities) and Government’s holdings of SDRs.

The Current Account (BOP)

Look at Table below where the structure of the current account in India’s BOP statement has been shown. Let us briefly discuss each of the above heads and subheads. 

1. Merchandise: Merchandise exports valued on F.O.B... (Free on board) basis, on private and government account are the credit entries data for these items. They are calculated from the various documents exporters fill and submit to designated authorities. Imports valued at C.I.F. (Cost, Insurance and Freight) are the debit entries. The difference between the totals of credits and debits appears in the 'Net' column. This is the balance on Merchandise Trade Account, a deficit, if negative and a surplus if positive. 

2. Non-Monetary Gold Movements: Gold is both a commodity and a financial asset. It is treated as financial assets when it is held by the monetary authority. "Monetization" of gold refers to the transaction when the monetary authority acquires gold, from residents and non residents to add to reserves. This gets recorded as a debit entry in reserve account and the offsetting credit entry is made in the non monetary gold account. Conversely, when the monetary authority acquires gold demonetization, reserve account shows a credit and the non monetary gold movement account shows a debit. Gold imported (or exported) by other agencies form a part of the merchandise trade account. 

Table: Structure of Current Account in India's Balance of Payments Statement.

3. Invisibles: Credits under 'invisibles' consist of services rendered by residents to non residents, income earned by residents on their ownership of foreign financial assets (interest, dividends etc.), income earned from the use, by non residents, of non-financial assets such as patents and copy rights owned by residents and the offset entries to the cash and in kind gifts received by residents from non-resident. Debits consist of same items with the roles of residents and non-residents reversed. A few examples may be cited as follows: 

• Receipts in foreign exchange, reported by authorized dealers in foreign exchange, remitted to them by organizers of foreign tourist parties located, I abroad for meeting hotel and other local expenses of the tourists. This will be a credit under "travel". 
• Freight charges paid to nonresident airlines or shipping companies directly will appear as debits under transportation. 
• Premiums on all kinds of insurance and re-insurance provided by Indian insurance companies to non-resident clients is a credit entry under "insurance", 
• Profits remitted by the foreign branch of an Indian company to the parent company represent a receipt of 'direct investment income', to be recorded as a credit entry under 'investment income', Interest paid by an Indian company on its borrowings abroad will appear as a debit. 
• Funds received from a foreign government for the maintenance of their embassy, consulates etc, in India will constitute a credit entry under 'Government not included elsewhere’.
• Foreign exchange earnings of Indian consultancy firms for professional services rendered to non residents will be recorded as a credit entry under miscellaneous. Similarly, professional services provided to residents by nonresident companies will appear as debit entry. 
• Revenue contributions made by the Government of India to international institutions or nonresident entities abroad will be recorded as a debit entry under ‘official transfer’. Simply, cash remittances for family maintenance received from Indian nationals working abroad will be a credit entry under private transfers. 

Look at Table 3.2 which gives you an idea about India's balance of 'payments:

The net balance between the credit and debit entries under the heads merchandise, non- monetary gold movements taken together is the Current Account Balance. The net balance is taken as deficit, if negative (debits exceed credits), a surplus, if positive (credits exceed debits).

COMPONENTS OF BALANCE OF PAYMENTS

The balance of payments is a collection of accounts conventionally grouped into three main categories with subdivisions in each. Three main categories are: 

a) The Current Account: Under this are included imports and exports of goods and services and unilateral transfers, which reflect government and private gifts and grants. 

b) The Capital Account: Under this are grouped transactions leading to changes in foreign financial assets and liabilities of the country. 

c) The Reserve Account: In principle, this is not different from the capital account it as much as it relates to financial assets and liabilities. However, in this category, only reserve assets are included. These are the assets which the central bank of the country uses to settle the deficits and surpluses that arise in the other two categories.

Balance of Payments

DEFINITION 
Balance of payment is an accounting record of the transactions between the residents of one country and the residents of the rest of the world over a given period of time. Transactions in which domestic residents either purchase assets (goods and services) from abroad or reduce foreign liabilities are considered uses (out flow) of funds because payments abroad must be made. Similarly, transactions in which domestic residents either sell assets to foreign residents or increase their liabilities to foreigners are sources (inflows) of funds because payments from abroad are received. Thus, in a way, it resembles a company's sources and use of funds statement.

UNDERLYING PRINCIPLES AND CONCEPTUAL FRAMEWORK
The balance of payment is part of a larger system of social accounts recording the economic activity of an economy and its various sections. The social accounts relate to economic transactions not only within the domestic economy but also between the domestic economy and the rest of the world. Balance of payment is concerned with economic transactions; five basic types of economic transactions may be distinguished. They are: 

a) Purchases and sales of goods and services against financial items i.e. the interchange of goods and services against claims and monetary gold;

b) Barter, i.e. the interchange of goods and services against other goods and services;

c) The interchange of financial items against other financial items e.g. sale of securities for money, or the repayment of commercial debts in money;

d) The provisions or acquisition of goods and services without requital, e.g. grants in aid;

e) The provision or acquisition of financial items without requital, e.g. In payment of taxes or as a gift.

The social accounts have common rules of credit and debit for recording economic transactions. Credit entries are made for the provision of goods and services or of financial items, whether they are sold, bartered, or furnished without requital. Debit entries are made for acquisition of goods and services or of financial items, whether these items are purchased, obtained by barter, or acquired without requital, for the first three types of transactions, the rules immediately result in equal credit and debit entries. For the remaining types, a credit entry for goods and services or financial items is matched by a debit entry for an unrequited transfer, and vice versa.

As stated earlier, balance of payments is concerned with economic transactions between the residents of the reporting country and the residents of the rest of the world. To acquire an in depth understanding, it is necessary to clarify the concept of residents. This term is certainly not identical with the term “citizen” though there is normally a substantial overlap. As regards individuals, ‘residents’ means those individuals whose general centre of interest can be said to rest in the given economy. They consume goods and services, participate in the productive process or otherwise carry out economic activity within the territory of the country on other than a temporary basis. Members of diplomatic and consular staffs and official missions, members of armed forces stationed abroad, and citizens undergoing medical treatment or studying abroad are considered residents of their own rather than of the country where they are staying. The extent to which other citizens living abroad are treated as residents (travelers) or foreigners (emigrants) depends upon a number of factors such as permanence of their living and the extent to which they shift their general "centre of interest". As regards non-individuals a set of conventions have been evolved. For example, governments and nonprofit bodies servicing resident individuals are residents of the respective countries. For enterprises, rules are somewhat complex particularly those concerning unit of corporate branches of foreign multinationals, According to IMF rules, these are considered to be residents of countries where they operate, though they are not a separate legal entity from the parent located abroad, international organizations like the UN, the World Bank, the IMF are not considered to be residents of any national economy even though their offices may be located within the territories of any number of countries.

BALANCE OF PAYMENT ACCOUNTING
The balance of payment is a standard double entry accounting record and as such subject to all the rules of double entry book-keeping viz. For every transaction two entries must be made. One credit (+) and one debit (-) and leaving aside errors and omissions, the total of credits must exactly match the total of debits i.e. the balance of payments must always balance.

Simple accounting rules followed in BOP is the following:

1. All transactions which lead to an immediate or prospective payment from the rest of the world to the country should be recorded as credit. Hence, all payments received for export of goods and services as also loans received abroad or inward foreign investment-whether direct or portfolio would be credit items,

2. Conversely, all transactions which result in an actual or prospective payment from the country to the rest of the world should be recorded as debits.

3. A transaction which results in an increase in demand for foreign exchange is to be recorded as debit entry while a transaction which results in an increase in the supply of foreign exchange is a credit entry.

Modern Theory of Trade

The contemporary theories of trade deviate from the assumptions of perfect competition and constant returns to scale made both in the classical and the neoclassical models. In the modern theories the market structure is either monopolistic or oligopolistic. In the former case a large number of producers produce goods that are not identical but differentiated in quality or design. In the latter case only a few producers serve the market with either identical products or differentiated products. The products which are just differentiated horizontally are similar in quality but different in design, like a red pen and a blue pen, white wine and red wine or wooden furniture and steel furniture. Vertical product differentiation involves quality differences as in small cars and large cars, lf the products are horizontally differentiated they are produced by more or less the same technology. Vertical product differentiation would. Invariably mean that the technology varies with quality or type of the product.

The modem theories assume economy of scale in production. An example of economy of scale is shown in the following Table:

One may easily check that the technology described above is a departure from the constant returns to scale we have been using so far. For example the output is doubled from 1 to 2 as labour is less than doubled from 3 to 5. Suppose that there are two similar goods, A and B being produced by the above technology, the economy has 10 units of labour. The consumers will consume the two goods in 1:1 proportion. Therefore the labour force will have to be equally divided in the production of the two goods and 2 units each of A and B will be produced and consumed in the economy. Now suppose there is another economy with the same technology to produce A and B having 10 units of labour. Then it is quite easy to see that one economy produces only A and the other produces only B and then trade with each other then the consumers in each country will be able to consume 3.5 units each of A and B and be better off than autarky. This is an example of trade taking place between two countries having the same technology and factor endowments simply due to economy of scale. But there is difference in the nature of trade. In the earlier models the products were different and produced by different technologies and the trade was between two industries, such as one country exporting cloth and importing wheat. This kind of trade is called inter-industry trade. But in the contemporary models trade is intra-industry, i.e., in the same industry located in two different countries. It is like one country exporting white wine and importing red wine - both goods requiring the same technology as in the above example. It turns out that a very substantial part of world trade is intra-industry in nature which shows the importance of modern theories in the contemporary world.

NEO CLASSICAL TRADE THEORY

The pattern of trade in the Ricardian theory depends entirely on the technological differences between two trading countries, as reflected in their respective labour productivity ratios. It does not depend on how much labour each country has. The neoclassical theory, on the other hand, focuses on the latter aspect, namely factor endowments. In contrast to the Ricardian theory the neoclassical theory assumes that there are at least two factors, say labour and capital which are used in the production of goods. But the two countries have the same technology or the same production functions. They differ only in respect of relative factor endowments : one country being relatively labour abundant and the other relatively capital abundant. If K is the total supply of capital and L the total labour supply, then [ WL], > [KL], implies that the home country is relatively capital abundant and the foreign country relatively labour abundant. This is called the physical definition of relative factor abundance. There is an alternative definition. If the foreign country is relatively labour abundant, then labour must be relatively cheaper there. In other words, if w is the wage rate and r the rental of capital, then [w/r]h > [w/r]f would imply that the home country is relatively capital abundant, or relatively scarce in labour endowment and would therefore have a relatively higher wage rate. One should note that the second definition does not necessarily follow from the first. The reason is very simple. A country may be relatively scarce ill labour, but this does not necessarily mean that the relative wage rate will be high because it is quite possible that there is very little demand for the goods that require the use of labour intensively. Similarly, in a country where labour is plentiful, wage rate may be still very high because of extremely high demand for the goods in which labour is used intensively. The lesson that we learn is that it is not possible to determine the price of a factor only by looking at its supply. One has to look at the demand side also.

Neoclassical trade theory is based upon the assumption that states act to maximize their aggregate economic utility. This leads to the conclusion that maximum global welfare and Pareto optimality are achieved under free trade. While particular countries might better their situations through protectionism, economic theory has generally looked askance at such policies... Neoclassical theory recognizes that trade regulations can... be used to correct domestic distortions and to promote infant industries, but these are exceptions or temporary departures from policy conclusions that lead logically to the support of free trade.

Historical experience suggests that policy makers are dense, or that the assumptions of the conventional argument are wrong. Free trade has hardly been the norm. Stupidity is not a very interesting analytic category. An alternative approach to explaining international trading structures is to assume that states seek a broad range of goals. At least four major state interests affected by the structure of international trade can be identified. They are: political power, aggregate national income, economic growth, and social stability. The way in which each of these goals is affected by the degree of openness depends upon the potential economic power of the state as defined by its relative size and level of development.

Let us begin with aggregate national income because it is most straightforward. Given the exceptions noted above, conventional neoclassical theory demonstrates that the greater the degree of openness in the international trading system, the greater the level of aggregate economic income. This conclusion applies to all states regardless of their size or relative level of development. The static economic benefits of openness are, however, generally inversely related to size. Trade gives small states relatively more welfare benefits than it gives large ones. Empirically, small states have higher ratios of trade to national product. They do not have the generous factor endowments or potential for national economies of scale that are enjoyed by larger particularly continental states.

The impact of openness on social stability runs in the opposite direction. Greater openness exposes the domestic economy to the exigencies of the world market. That implies a higher level of factor movements than in a closed economy, because domestic production patterns must adjust to changes in international prices. Social instability is thereby increased, since there is friction in moving factors, particularly labor, from one sector to another. The impact will be stronger in small states than in large, and in relatively less developed than in more developed ones. Large states are less involved in the international economy: a smaller percentage of their total factor endowment is affected by the international market at any given level of openness.

Ricardo’s theory of trade

David Ricardo was one of the most influential economists of the early nineteenth century, but he came to economics by a circuitous route. Born to a Jewish family in Amsterdam, he left the country and broke off relations with his family (and they with him) to avoid an arranged marriage — he married a Quaker instead. He set himself up in London as a government securities dealer and became, in his words, “sufficiently rich to satisfy all my desires and the reasonable desires of all those about me.” Looking for something to occupy his time, he developed the modern theory of international trade.

Many people of Ricardo’s day (and ours!) regarded trade as a zero-sum activity: if you gain from trade, then I must lose. As Adam Smith in his Wealth of the Nations puts it:

All political writers since the time of Charles II had been prophesying that in a few years we would be reduced to an absolute state of poverty [by international trade], but we find ourselves far richer than before.

That trade is good for consumers is easy to understand; more trade means more choices and having more choices is at least as good as not having them. That trade is good for producers is a bit less immediate. The argument uses the idea of specialization. Take Minnesota and Florida: Minnesota is good at producing corn and Florida’s good in producing oranges and both Minnesotans and Floridians like to consume oranges and corn. In absence of trade some oranges will be produced in greenhouses in Minnesota and some corn will be grown in the Florida swamps: but productivity in those two activity is not very high and thus producers in those two sectors will not be doing very well. When Florida and Minnesota open up to trade Minnesota can specialize in corn and Florida in oranges, meaning, for example, that producers of oranges in Minnesota can turn to producing corn. The demand for their corn will come from Florida and they will have higher productivity so they are also better off. But this story relies on absolute advantage (Florida on oranges and Minnesota on corn) and that was Smith had in mind. What if Florida is better than Minnesota in both oranges and corn?

Ricardo insight was that trade is advantageous even in this situation. What matter is not absolute advantage but comparative advantage, that is as long as Minnesota is better than Florida in the corn to orange ratio (even though it is worst than Florida in both) then trade will be advantageous to both. This result has been referred to one of the few in results economics which is neither trivial nor false, so in class we will discuss the Economist’s note “The miracle of trade” in detail.

The note develops Ricardo’s theory in a particularly simple setting: two countries produce and consume two products, and both products are produced with labor alone. In many respects this version of the theory is unrealistic, but the lack of realism is exactly what makes the analysis simple and understandable. We’ll discuss later whether the lack of realism plays an undue role in our conclusions. (For the most part, it does not.)

Bottom line

• The driver of trade are differences in prices. In absence of trade wine is expensive in the North and cheap in the south. That calls for the North to buy wine from the South. The symmetric holds for bread.
• Why is South producing and exporting wine when the North could do it more efficiently? Because wages of wine producer in the South are lower. Think like this: how much bread does it cost in the North to switch one worker from bread to wine? 1 loaf. How much in South? only 1/3 of a loaf.
• Consumers are better off in both countries with free trade because they both take advantage of cheap goods.
• Free trade changes the distribution of production. In this case, the North shifted out of wine into bread, and the US did the reverse. In other models, the change in production may not be so extreme, but it’s generally true that they predict that every country will stop producing some products, and import them instead. The result is a far more efficient system of production, as each country produces those goods for which its relative productivity is the highest.
• Moving to free trade is similar to an increase in productivity: when you shift production to high productivity products, aggregate productivity rises. The impact is similar to our discussion of capital markets. Countries with good capital markets allocate capital more effectively to the high-return projects and increase aggregate productivity as a result. This is a natural feature of trade models. If we were NIPA people, we might compute GDP like this: sum production of wine and bread, valued at a fixed set of prices. In this case we’ll use the free trade prices, which is similar to PPP adjustment (apply the same prices in every country). GDP at world prices (in bottles of wine) is Free Trade No Trade.
  

Once trade shows up in GDP, it shows up in aggregate productivity, too. We don’t have capital in this model, so the production function is Y = AL. Since L is unchanged across trade regimes, the change in Y reflects an increase in TFP.

• No jobs were lost — or found. In our example, every unit of labor was used whether trade was possible or not. This is only a little extreme: no trade models suggest that trade will have much long run impact on employment. Any effect there might be comes from the impact on labor supply of an increase in the wage. So when you read the newspaper, especially in an election year, remember: trade has an impact on what the jobs are, not on how many there are.

THEORIES OF INTERNATIONAL TRADE: INTRODUCTION & OBJECTIVES

INTRODUCTION OF TRADE THEORIES

Foreign trade has recently, and particularly after 1991, become an important as well as debatable issue for the Indian economy. The Union budget presented in 1991 introduced a wide range of economic policy reforms related with industry and trade, ushering in an era of economic liberalism in the Indian economy. These reforms were designed to transform a closed and inward-looking economy into an open and outward-looking one by lifting controls on  import  and export of goods and services and by  making rupee convertible. In the years that followed, our trade and industrial production have been growing at fairly high rates.  There is no doubt that the liberal approach to economic policy will continue and the previous bias against international trade and investment will remain subdued in the foreseeable future.  In this new economic environment the, teaching of economics will develop a serious gap if the students are not made aware of the basic principles and concepts of international trade. 

OBJECTIVES OF TRADE THEORIES

The purpose of a trade theory is to explain the pattern of trade between two countries.  What is meant by pattern of trade? Suppose India exports garments, gems and jewellery and a few other products to the United States, while the latter exports computer parts, such as hard disks, and other machines to India. This pattern of export and import of goods is known as the pattern of trade. The theory of international trade explains why such a pattern emerges and lists the factors which cause such a pattern. Trade between two nations is not just in goods. Trade in services is also quite important. If the United States provides banking and insurance services to the Indian citizens, say to the Indian exporters and importers, and if these services are provided from the United States, then it is to be regarded as the U.S.  Export of services to India. There are two main theories on pattern of trade: the classical or the Ricardian theory and the neoclassical theory or the Heckscher-Ohlin-Samuelson theory.

The second objective of trade theory is to explain the pattern of specialization. A pattern of specialization tells us the kinds of products and their quantities a country would produce. In the above example, India would produce garments, gems and jewellery and other products and the United States would produce computer parts and other machines. India may or may not produce computer parts and machines which USA would produce and similarly USA may or may not produce garments and the gems and jewellery. The pattern of trade and the pattern of specialization will depend on the model you are using to explain these patterns. If you are using the Ricardian theory then you come to the conclusion that USA would not produce garments or gems and jewellery in which India has specialized. But if you are using the neoclassical theory then you would say that USA would produce the goods it is importing from India. The domestic industries that produce the goods that the country imports are known as import competing industries (e.g.  Garments for USA computer parts for India) and those producing goods that the country exports are called export industries (e.g.  Computer parts for USA and garments for India). A country however will have industries whose products are neither exported nor imported and the goods produced by them are called non traded goods, such as domestic transportation, electricity, etc.

The third objective of trade theory is to show that international trade is mutually beneficial to the trading countries. A country which is not engaged in trade with any country is in a state of autarky. The theory says that trade is better than autarky under any circumstances. However, how much trade a country should have and whether a country should restrict the quantities of exports and imports by customs duties, tariffs, quotas and taxes is quite another matter.

ECOLOGICAL ENVIRONMENT

Ecology refers to the pattern and balance of relationships between plants.  Animals, people and their environment. Earlier there was hardly any concern for the depletion of resources and pollution of the environment. Smoke stemming from the chimneys and the dust and grime associated with factories were accepted as a necessary price to be paid for the development.  But  in recent years, the magnitude and nature of the  'pollution  overload'  have assumed such  alarming proportions that pressures have built  up  all  over the world to  do something urgently  lest the  situation gets out of control. In almost all the countries, there exist today legislation and codes of conduct to preserve the earth’s scarce resources and put a halt to any further deterioration in the environment. Business operations of the international firms are no exceptions and have been brought under such regulations. Very recently, the United States government imposed a ban on exports of marine products from countries including India which did not have special devices fitted into fishing trawlers to free the tortoises trapped during fishing expeditions. Similarly, restrictions have been put on garment exports using cloth processed through the use of AZO dyes. Germany today is perhaps the country with most stringent environmental laws in the world.

The concept of industrial progress and development has also undergone paradigm shifts. Corporations today are judged in terms of not only financial returns, but also conservation of environmental resources and reduction in pollution levels. Green technologies, green products and green companies are highly valued in today’s global market place.

LEGAL ENVIRONMENT

Every business firm operates within the jurisdiction of legal system. This is true of domestic as well as international firms. But the problem for the international firm is that the laws that they face in their home countries might be different from those encountered in the host countries. Advertising Laws in  West Germany, for instance, are so strict that is best advised for the international marketer to get himself  good legal counsel before framing his advertising strategy in  West Germany, Similarly there exist laws in European countries preventing promotion of products through price discounting. These laws are based on the premise that such practices differentiate buyers.

Different Laws exist not only in  the area of marketing mix variables but also for other business decisions like location of plant, level of production, employment of people,  raising money from the market, accounting and taxation, property rights including  immovable ,property and patent  and trade marks, cancellation of  agreements.

Besides  directly  influencing firm's  business  operations, laws affect the environment within which a firm operates in  the foreign country, Thus while one country may promote competition within  its markets through  its legal system, another country might try to protect its industry and thereby restrain competition. In the United States, for instance,' anti-trust legislation influences all mergers, take-over, and business practices which we in restraint of trade, Court’s verdicts in this respect are governed by paragraph one of Sherman Act.  Gillette, for example, was prevented from taking over Braun A.G. of West Germany which was an electric razor manufacturer on the grounds that it ~would distort competition.

A major problem with laws in different countries is that the legal systems of the world are not harmonized and are in fact based on contradicting legal philosophies. The legal systems that exist in different countries of the world are antecedents of one of the two legal philosophies, viz., common law and code law. Common law finds it roots in Britain and is practiced today in the United States, United Kingdom and Canada. The basis of common law is tradition, past practices and past rulings of higher courts that look upon similar problems within the accepted set of laws. Code law, on the other hand, is based on Roman law and is an all inclusive system of written rules that encompass all eventualities.  One important business implication of the two legal philosophies is that the judgments awarded in the case of a commercial dispute can be radically different.  To illustrate, let Us take the interpretation of non-fulfillment of required conditions of a contract under ‘act of god'.  What constitutes an ‘act of god’ in code law is not necessarily the same under common law. Thus while strike by workers may be looked upon as an ‘act of god’ in code law, it will definitely not be a reason for non-fulfillment of the contract under the common law.

In last few decades, efforts have been made to evolve international laws, International laws deal with upholding orders. Originally these laws recognized only nations as entities, but today these laws also incorporate role played by individuals. International laws may be defined as a set of rules and regulations which the nations consider binding upon themselves. This definition brings out two important characteristics of international law. One there is absence of the existence of a comprehensive legal system. There is truly no comprehensive body of law because as stated earlier international commercial law is of recent birth. This has had a direct bearing upon the existing administering authorities. As of today, there are only a few international bodies for administering justice.  These include international Court of Justice founded in 1946 and the World Court at Hague. Second characteristic  of the international law relates to  the fact that no nation  can  be  forced  into these  rules  as stated in  the phrase  'consider binding upon  them'.  Since all nations recognize the sovereignty of the legal systems, international judgments are, therefore, based on the premise of good humanity and not on the basis of any particular country's legal system.

In the absence of laws having jurisdiction over sovereign countries, a major problem faced by the international business firms is which country’s laws, viz...  Host country’s or home  ' county’s or third country’s laws, shall be binding in the case of a dispute. Firms also need to be aware of different modes of the settlement of trade disputes and role of international Chamber of Commerce’ Court of Arbitration.

POLITICAL ENVIRONMENT

It is rightly said that a foreign business firm operates only as a guest and at the convenience of the host country government. The government reserves the right of allowing a foreign firm to operate in the country as well as laying down the manner in which a foreign firm can conduct business. To gain  an  insight into a foreign  country's political environment, one needs to  analyze factors such as current form of government and political party system, role of government in  the economy, political encouragement to foreign firms, political stability, and  political risks to  business.

Form of Government and Political Party System: Government in a foreign country can be either parliamentary or absolutist. While the parliamentary type of government is run by people's representatives selected from time to time, the absolutist government assumes the form of absolute monarchies or dictatorships, and only a select few make policies. In the case of parliamentary government, one needs to know whether it is a single party system or multiparty government system. Single party government is considered to be more stable than the multiparty government.

Political Ideology and Role of Government:  Besides political party system, one must have knowledge about the political ideology and government attitudes toward foreign business and investment. In addition to regulatory role, government itself can be directly involved in business. In such cases, government enterprises emerge as dominant players in the market and pose tough competition to the foreign firms. Even supplying goods and services to the government agencies is not hassle free. Because of monopsonic power of the government organizations, it becomes quite arduous to negotiate prices and other terms with them.

Political Stability:  Stability of the government and government policies are a major concern for the international firm. Since business decisions, these days involve huge investments and are irreversible, what the foreign firms look in for is politically stable countries. Political instability can result from either change in the type of government, a shift in-political parties that form the government or change in the government policies without change in the government or shifts in political parties.

Political Risk: Political risk which is defined as the vulnerability of a project to the political acts of a sovereign government is a big threat to foreign business. The political acts leading to political risks can range from confiscation, expropriation, nationalization, domestication to restrictions on transfer of finds. Confiscation occurs when a foreign investment is taken over by a government without any compensation. Expropriation takes place when the, government takes over foreign investment but some compensation is paid. The compensation may or may not equate with the market value of a firm. Nationalization affects the entire industry rather than a single company, and involves transferring ownership of the confiscated or expropriated business to a national firm or government entity.

Domestication is a mild form of intervention and involves transfer of control of foreign investment to national ownership to bring the firm's activities in line with national interest. It differs from expropriation in the sense that it is gradual encroachment of the freedom of operation of a foreign operator. Domestication can be either firm initiated, government initiated or predetermined. Whereas firm initiated and predetermined domestication entail low levels of risk, government initiated domestication is quite risky and is ranked with expropriation.

Another type of risk relates to a temporary or permanent blocking of finds.  Unlike other kinds of risks, a business firm under blockage of funds owns the funds and property rights but it cannot remit the funds or earnings back to home country. This was a common problem faced by Indians during Amin’s rule in Uganda, although the government did not formally make any announcements regarding takeover of property, it became almost impossible for the firms to repatriate their earnings in any form. No doubt black money market operations may exist in any country; it is difficult for such operations to handle large scale of funds involved.

International firms need a proactive approach to deal with political risks.  An effective management of risks calls for recognizing the existence of various kinds of political types of risks and their consequences, and developing appropriate plans and policies to deal with such risks.

SOCIO-CULTURAL ENVIRONMENT

Business is as much a socio-cultural phenomenon as it is an economic activity. Per capita income in two countries may be the same, yet the consumption patterns in these countries may differ. Socio cultural forces have considerable impact on products people consume; designs, colour and symbols they like; dresses they wear and emphasis the place of religion, work, entertainment, family and other social relations. Socio-cultural environment influences all aspects of human behavior and is pervasive in all facets of business operations.

Culture can be defined as a "sum  total of man's  knowledge, beliefs, art, morals, laws, customs and  any other capabilities and habits acquired by man  as a member of society."  It is a distinctive way of life of group of people, their complete design of living. Culture thus refers to a man's entire social heritage - a distinctive life style of a society and its total value system which is intricately related to be consumption pattern of the people and management philosophies and practices.

Furthermore, within each culture there are many subcultures that can have business significance. For instance, in a country like United States distinct subcultures prevail in the South, North-Eastern or Midwestern parts. Subcultures are found in all national cultures and failure to recognize them may create impressions of sameness which in reality may not exist. A single national and political boundary does not necessarily mean a single cultural entity. Canada, for instance, is divided between its French and English heritages, although politically the country is one. Because of such distinctive cultural division, a successful marketing strategy among the French Canadians might not effectively work among the English Canadians or vice-versa. Similarly a single personnel policy may not work with workers employed in two different plants if they belong to different sub cultural groups and differ in their work habits and underlying motivations.

Elements of Culture

Some of the important elements to understand a country's culture are: language, aesthetics, education, religions and superstitions, attitudes and values, material culture, social groups and organizations, and business customs and practices.

Language: Language is an important element of culture and it is through language that most of the communications take place. An international marketer should have a thorough under- standing of the language of the market - particularly the semantic differentials and idiomatic nuances which are essential characteristics of all languages of the world. Dictionary translation could be quite different from the idiomatic interpretation of a language. When literal translations are made of brand names or advertising messages from one language to another by people who know the language but not the culture, serious mistakes may occur. When General Motors of the United States literally translated its marketing phrase ‘Body by Fisher’ into Flemish language, it meant ‘Corpse by Fisher'.  Similarly, the phrase "Come alive with Pepsi" faced problems when it was translated into German advertisements as "Come out of grave" or in Chinese as "Pepsi brings your ancestors back from the grave". When the American car called ‘Nova’ was introduced in Puerto Rico, sales were poor until the company realized that the word Nova was pronounced as ‘Nova’ - which literally meant in Spanish "does not go".  Sales were better when the name was changed to 'Carbie'.

Aesthetics:  Aesthetics pertain to a culture's sense of beauty and good taste, and is expressed in arts, drama, music, folklore, dance and the like. Aesthetics are of special interest to the international business executives for these govern the norms of beauty in a society and are helpful in correctly interpreting meanings of various methods of artistic expressions, colours, shapes, forms and symbols in a particular culture. Colours, for instance, mean different things to different people. The colour of mourning is black in the United States, but it is white in the Far East. Green is restful colour to Americans, but it is disliked by people in Malaysia where it connotes illness and death. Symbols also need to be interpreted correctly, Seven, for instance, signifies good luck in the United  States but just  opposite in Singapore, Ghana and  Kenya. Use of number four should be avoided in Japan because it is pronounced as ‘shi’ which in Japanese means death. Sensitivity to the aesthetics of a society and their symbolic expressions can greatly help in avoiding socially embarrassing situations and correctly designing the products and messages.

Education:  Education is generally understood as formal schooling. But it is better to adopt a broader perspective and define education as any process, formal or informal, through which one learns skills, ideas and attitudes. Education is important as it affects not only the education levels but also the development of mental faculties and various skills, In general, educated people have been found to be more sophisticated, discriminating and receptive to new products and ideas. Availability of educated manpower like skilled labour, technicians and professional is also dependent on the country’s education level. Media to be used by a company for promoting its products as services are also dependent on education level prevailing in the country. The conventional forms of printed communications, for instance, do not work in countries where literacy rates are low.

Religions and Superstitions:  Religions are a major determinant of moral and ethical values and influence people’s attitudes, habits and outlook on life which are reflected in their work habits and consumption patterns. Dr.  Ernest Dichter observed: "In puritanical cultures, it is customary to think cleanliness as being next to godliness. But in Catholic and Latin American countries, to fool too much with one's body to overindulge in bathing or toiletries, has the opposite meaning. It is that type of behavior which is considered immoral and improper". There are numerous religions and faiths in the world, with prominent ones being: Animism, Buddhism, Christianity, Hinduism, Islam and Shinto. Each one has its own morals and codes of conduct. A working knowledge of the religions prevalent in the target markets helps in understanding people's work habits, underlying motivations and consumption behaviors. Equally important are the superstitions of the people in a society.  People’s beliefs in astrology, hand reading, ghosts, lucky days and places are integral part of certain cultures. In some countries, single storey houses are preferred because it is considered bad to have another's foot on one’s head. Location of a building and its architecture in many Asian countries is governed by the principles of ‘vastushastra’ rather than purely geographical and economic considerations.

Attitudes and Values: Besides religions and superstitions, one must be cognizant of attitudes, values and beliefs prevalent in a society. These attitudes and values may relate to consumption level, material possessions, risk taking and change. ‘What is important and desirable' differs from society to society and is largely governed by the attitudes and value existing in a society. Americans in general are more receptive to change and risk taking, but people in many societies are averse to change and risk taking. They prefer doing what is traditional and safe. New products are not accepted unless these have the approval of local chiefs or religious leaders.

Material Culture:  According to Ball and McCulloch, material culture refers to all manmade objects and its study is concerned with how man makes things and who makes what and why. While the question 'how it relates to technology, other questions ‘that’, ‘what’ and ‘why’ are part of economics.

Technology includes the ways and means applied in making of material goods. It is technical know-how in possession of the people of a society. Choice of technology has its repercussions to the size of investment, scale of operations as well as type and amber of workers to be employed. Technology transfer has been a highly controversial issue in the past. Because of supply of obsolete or inappropriate technology, many developing countries have laid down stringent rules and regulations concerning technology imports and payments. Since transfer of new technology is often riddled with workers’ resistance to change and public criticisms, multinational corporations are advised to have suitable action plans to counter such opposition. Economic aspects of material culture, i.e., who, what and why, have already been discussed before.  It is suffice to say here that these elements influence the level of demand as well as types and quality of goods in demand, and consumption pattern in a society. Business implications of material culture of a society are obviously many. The goods and services that are acceptable in one market may not be acceptable in another market because of differences in material cultures of two societies. For example, sophisticated electronic appliances widely in demand in the technologically and economically advanced Western countries may not find a market in the less developed countries of Asia, Africa or Latin America.

Social Groups and Organizations: A study of social groups and organizations is important as it determines how people relate to one another and organize their activities. The size and cohesiveness of the family, role of men and women in society, and positions of different social classes differ from country to country. Social groups and organizations mould the pattern of living and interpersonal relationships of people in a society. They influence the behavioral norms, codes of social conduct, value systems, etc., that may be of relevance to the international business managers in their decision making.

Business Customs and Practices:  A familiarity with business customs and practices prevalent in different countries is a must to avoid business blunders. An international business manager must have necessary knowledge about how business is conducted and what importance business people in a foreign country attach to work, time, formality, change and achievement. American managers, for instance, are by nature highly work oriented and attach upmost importance to speed and punctuality in business dealings. They are, moreover, highly achievement oriented and fond of new things. But people in other parts of the world do not share these values and beliefs. Japanese, for instance, are also workaholics but they are very slow in decision making Latin Americans too do not believe in haste and spend considerable time in socializing and developing friendships before coming to business transactions.

A  person  dealing with people from different cultures should  be well aware of differences in the number and nature of stages  involved  in  business negotiations  anal  formalities to be observed  in  concluding business  contracts. While  in  countries like the United  States it is necessary to have final  agreement in  writing, this practice  is  not  much appreciated  in  many West Asian  countries where oral agreement  alone is considered more  than  sufficient.

ECONOMIC AND FINANCIAL ENVIRONMENT

Among the entire uncontrollables, economic environment is perhaps the most important factor. An analysis of economic environment enables a firm to know how big the market and what its nature is. Answers to these questions in  turn  determine  whether  a firm should enter a given  foreign market,  and if  yes, what strategies it should use to successfully run  its business operations, Closely related to the economic environment is the financial environment which  affects a firm's capital structure, investment decisions  and  accounting practices.

Various dimensions one needs to consider while attempting an economic and financial analysis include: foreign country’s level of economic development, income, expenditure pattern, infrastructure including financial institutions and system, inflation, foreign investment in the country, commercial policy, balance of payments account, accounting systems and practices, and integration of the foreign country’s foreign exchange, money and capital markets with the rest of the world. Let us learn this economic and financial environment in detail.

Economic Environment

Economic environment is the most important indicator of the global market analysis. Let us discuss the major economic indicator influencing the foreign market decisions.

Economic Development: Economic development is directly related to the development of marketing in a country. Countries characterized by high levels of economic development not only have high demand for a variety of products, but also have better infrastructure and more developed marketing systems. Competition is also high in these countries. In the less developed countries, on the other hand, not only demand is low, but infrastructure is also poor. It, therefore, becomes quite difficult and more expensive to do business in such nations.

Income:  Income is an important indicator of the country’s level of development and also its market size. Gross national product (GNP) and per capita income are among the major measures of income.  While sales of most of the industrial goods and capital equipment generally correlate with GNP, demand for consumer products depends on per capita income.

Besides income, one should acquire information about the sectoral distribution of the GNP as it is an important determinant of kinds of goods in demand in a foreign country. If the majority of a country’s GNP comes from agriculture, it implies that the country is agriculture based and it shall have a good demand for agricultural inputs such as seeds, fertilizers, pesticides and agricultural machinery and tools. An industrial nation with relatively higher dependence on manufacturing, on the other hand, shall have a good market for raw materials, plant and machinery, and also for a variety of consumer durables and non-durables.

Though per capita income is a useful measure, it is not a full-proof measure of the country's development and prosperity. What is more relevant is the distribution of income. While in the developed countries income distribution is relatively more even, it is highly skewed in the developing countries. Since only a small portion of the population accounts for 60 to 70 per cent of the country’s GNP and the rest are poor in the developing countries, market for high priced product and non-essential products is limited only to select rich people.

Expenditure Pattern:  Data on expenditure patterns are useful in judging as to how the money is spent on different item and which products receive more weight age.

Infrastructure: Infrastructure is another vital dimension of the country’s economic environment and is directly related to the country’s economic development. Infrastructure refers to various social overheads such as transportation, telecommunications, commercial and financial services like advertising, marketing research, various media, warehousing, insurance, and distribution, credit and banking facilities.  Absence of adequate infrastructure not only hinders country’s development but also affects firms’ costs and capacity to reach various market segments. Companies find it difficult to co-ordinate and control their business in countries with poor communication systems.

Financial Environment

Sound financial positions of the country coupled by the favorable investment policies reflect strong demand potential.  Let us briefly learn important financial indicators.

Monetary and Fiscal Policies:  Inflation, interest rate, various kinds of duties and exchange rates are the variables related  to the country's monetary and fiscal policies and have a substantial impact on the costs and profitability of business operations. These variables also influence firm's decision to move funds from one nation to another.

Commercial and Foreign Investment Policies: Each country has its own commercial and foreign investment policies which must be studied in detail to ascertain country’s openness to trade and investment with other countries. A proper understanding of these policies can be quite helpful in ascertaining what tariff and non-tariff barriers the particular country uses to protect its domestic industry from foreign competition. The country may plan to minimize the incidence of these trade measures.

Balance of Payments Account: A country's balance of payments account is another major source of information about the country’s foreign trade and foreign currency reserves. The current account throws light on the country’s exports and imports as well as its major sources of imports and destinations of exports.  Capital account reveals stocks of foreign investments, borrowings, lending and foreign exchange reserves. An international firm must be duly aware of exchange controls prevalent in the foreign countries. Countries running deficit in their balance of payment accounts generally impose controls on movement of foreign exchange into and out of their economies. These controls prompts the multinational corporations to resort to transfer pricing mechanism,  i.e.,  over invoicing  of imports and under pricing of exports so as to move out more than permitted finds from such countries.

GEOGRAPHIC ENVIRONMENT

Geography is an important component of the foreign environment and refers to a country's climate, topography, natural resources and people.  Everyone engaged in international business must have some knowledge of geographic features of the foreign country as these influence the nature and characteristics of a society. It also affect demand pattern of the people living in the country.  Geography is a major contributory factor to the development of business systems, trade centers and routes.

Different climatic conditions (viz., rain, snowfall, wind, temperature, humidity, etc.,) give rise to demand for different types of products. It is largely due to climatic differences that people differ in their housing, clothing, and food, medical and recreational needs.  Many a time needs are same, and the same products are demanded. But because of the climatic and topographic differences, products need adaptation or modifications to suit local conditions. Rolls Royce cars from England, for instance, required extensive body  work and  renovations in  Canada  because the  salted sand, spread  over streets to keep them  passable throughout four or five months of virtually continuous snow in  Canada, caused  rusting and corrosion in  the fenders and door panels and  oil system also developed  leaks.

Geographic conditions also affect a firm’s plant location decision.  A  firm prefers to set up its manufacturing plant  in  a  country which  has favorable climatic  conditions, possesses suitable topography  (i.e.,  surface features  such as hills, plains, river  and  sea) and  where raw materials, energy and  labour are cheaply  and  abundantly  available. Foreign country’s nearness to other markets and its strategic location on major trade routes are other equally important considerations.

Firms'  distribution and logistics strategies are directly  influenced by  geographic  conditions in the foreign markets,  Re-order points  and safely level stocks are kept generally higher for those countries  or places which are not easily accessible  and  can be  cut off suddenly and heavily due to bad  weather. Location of a country on the world map is an equally important consideration. It affects its trade prospects with other countries.  Landlocked  countries such as Bolivia, Zambia and Zimbabwe ,are not only costly to reach  but are also difficult  to penetrate as trading with these countries depend  upon  their relations  with neighboring  countries through  which goods have to cross.

Consumer demand for many a low priced and essential product is directly related to the number of people living in a country. It is primarily due to large populations that  the countries  like China and  India  have  become  the targets of the  multinational  corporations which are vying with one another to gain  a foothold  in these markets. To arrive at a correct estimate  of the market size, however, one needs to take into account other factors also such as population  growth, population  density and population distribution  by age, income, location and  occupation, taken together, these variables provide better estimates of the present  and future market  potentials  and also help  in  providing information  relevant for communication,  distribution,  product  quality  and pricing  decisions.