Intrernational Trade Assignment 1

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Muhammad Irfan Arshad

Roll No: AX846575

Professor Dr. Syed Aamir Shah

LEVEL: MS (MANAGEMENT SCIENCES)

Date: 30th July 2014

INTERNATIONAL BUSINESS AND FINANCE (8702)

SEMESTER: SPRING 2014

ASSIGNMENT No. 1

(Units: 48)

ALLAMA IQBAL OPEN UNIVERSITY, ISLAMABAD(Department of Business Administration)

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Question 1: Make a comparative study of Mercantilists view regarding trade andabsolute theory of international trade?

Mercantilism and its influence on International Trade

Mercantilism was found in early 16th century England, from where it later spread to France and

other European countries. Its origin was associated with many geographical and technological

breakthroughs of that period including discovery of America by Columbus in 1492 and vasco

de Gamas navel route to India in 1498. A new class was born merchants and mercantilism

was the political economy of state building.

The term Mercantilism was coined be Maques de Mirabeau (a Physiocrat) and ranges the

period roughly from 1600-1800. It is a system closely associated with the rise of nations and

concept of Nationalism. It was a system prevalent in France, Spain, England and Holland.

Thomas Mun is considered as the most widely known mercantilist thinker.

The basis of mercantilist view can be summarized into following two statements:

i. Economic health of nations is measured by the amount of precious metals (gold and

silver) it poses.

ii. The only way for a nation to increase its wealth, is the import of precious metals from

abroad; either direct import from colonies or international trade.

Mercantilists therefore considered positive trade balance as essential and used any economic

policy measures to promote this goal. They regarded international trade as zero sum game.

There are two basic types of Mercantilism:

i. Early mercantilism or bullionism: its main goal was to accumulate precious metals

and any export of precious metals was strictly prohibited.

ii. Developed mercantilism: Its main goal was to ensure active trade balance and to

provide support of manufacture production. It preached the necessity of maintaining

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domestic consumption to a minimum in favour of exports and the need to maintain

wages at lowest level (labor theory of value)

Mercantilists considered following economic policies:

Strict prohibition of the outflow of precious metals abroad.

Obligation to pay for imports with exports

Restriction on imports of finished products from abroad.

Support for the establishment of manufactories

Establishment of commercial monopolies

Ban on export of raw materials and semi products and promotion of their imports.

Laws of trade and navigation

Regulation of wages

Maintaining a trade surplus

Intervening through trade activities through Govt. Intervention

Colonising new territory.

Support for population growth and immigration

Mercantilism faced a heavy criticism. David Hume in his Theory of self regulation of trade

balance pointed out that accumulation of precious metals will inevitably lead to increase in

prices and wages hence increasing inflation, ultimately the country will lose its competitive

advantage. Similarly Adam Smith also criticised that the source of wealth is labor and active

balance of trade leads to an impoverished country. He also explained that liberalism is better

than protectionism and trade is a positive sum game.

Theory of Absolute Advantage of International Trade

Adam Smith (1723 1790) was a Scottish moral philosopher and a pioneer of political

economy proposed a famous Theory of Absolute Advantage of International trade in 1776.

Theory states that a country that has an absolute advantage can produce a more substantial

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output of goods or services, than other nations using the same amount of, or fewer resources.

Theory is based on the following assumptions:

2*2*1 model (2 countries, 2 goods and 1 factor of production)

Homogeneous goods

Labor is homogeneous within the country but heterogeneous across the countries

Complete mobility of labor in the country but strict immobility of labor across the

country.

No transportation costs

Full employment

Production technology difference exists across industries and across countries and is

reflected in labor productivity parameters.

The labor and goods markets are assumed to be perfectly competitive in both countries

Firms are assumed to maximise profit while consumers (workers) are assumed to

maximise utility.

The basic idea of theory lies in the fact that biggest and natural advantages of international

division of labor occur, when countries specialise in producing those good that they can

produce with the lowest overall costs and import goods that other countries produce at the

absolute lowest costs. Smith demonstrated his idea on the example of wine production in

Scotland.

Slovakia and Hungary produce two goods: sheep cheese (bryndza) and sausage

Bryndza SausageSlovakia 5 hrs/1Ton 10 hrs/1 Ton

Hungary 10 hrs/1 Ton 2 hrs/1 Ton

Here absolute advantage exists because of difference in natural and climatic conditions andtechnologies.

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Wheat Milk

England 1 hrs/1Ton 5 hrs/1 Ton

Germany 2 hrs/1 Ton 4 hrs/1 Ton

England uses 300 hours (200 wheat 100 milk) and Germany uses 600 hours (300 wheat- 300Milk

Question 2: Discuss H.O. Model with its assumptions and also explain that howcountries trading under this theory gain from trade.The Heckscher-Ohlin (H-O) theory provides the basis for significant theoretical

developments of international trade by explaining that countries trade depends on their factor

endowments and that the earnings of factors are affected by trade. It also tells us why

countries involve in trade of goods and services with other countries. Technically, Heckscher-

Ohlin model is the general equilibrium mathematical model of international trade theory

based on the Ricardian theory of comparative advantage by making prediction on trade

patterns and production of goods based on the factor endowments of nations.

Empirically, its most basic proposition lies on the fact that a country exports goods that use

their abundant factors intensively and imports goods that use their scarce factors intensively.

The theory implicates two things: first, different supply conditions in terms of resource

endowments explain comparative advantage and second, countries export goods that use

abundant and cheap factors of production and import goods that use scarce and expensive

factors.

According to Heckscher-Ohlin theory, international and interregional differences in

production costs occur due to the differences in the supply of factors of production. Under

free trade, countries export the commodities whose production requires intensive use of

abundant factors and import the commodities whose production requires the scarce factors.

Hence, international trade compensates for the uneven geographic distribution of factors of

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production. The theory gives insight to the fact that commodities are the bundles of factors

(land, labour and capital). Thus, the exchange of commodities is indirect arbitrage of factors

of production and the transfer of services of otherwise immobile factors from regions where

factors are abundant to regions where they are scarce.

A nation exports the commodities which are produced out of its relatively abundant and

cheap factors or resources and imports the commodity which is produced out of relatively

scarce factors or resources. In another words, relatively labour abundant country exports

relatively labour intensive commodity and imports the relatively capital-intensive

commodity.

Assumptions of the Heckscher- Ohlin Model

Heckscher Ohlin mode is based on a number of explicit and implicit assumptions. The

important assumptions of the model are:

1. There are only two nations, with two goods for trade two factors of production

(capital and labour).

2. Both nations use the same technology and they use uniform factors of production.

3. In both countries, good X is labour intensive and Y is capital intensive.

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production. The theory gives insight to the fact that commodities are the bundles of factors

(land, labour and capital). Thus, the exchange of commodities is indirect arbitrage of factors

of production and the transfer of services of otherwise immobile factors from regions where

factors are abundant to regions where they are scarce.

A nation exports the commodities which are produced out of its relatively abundant and

cheap factors or resources and imports the commodity which is produced out of relatively

scarce factors or resources. In another words, relatively labour abundant country exports

relatively labour intensive commodity and imports the relatively capital-intensive

commodity.

Assumptions of the Heckscher- Ohlin Model

Heckscher Ohlin mode is based on a number of explicit and implicit assumptions. The

important assumptions of the model are:

1. There are only two nations, with two goods for trade two factors of production

(capital and labour).

2. Both nations use the same technology and they use uniform factors of production.

3. In both countries, good X is labour intensive and Y is capital intensive.

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production. The theory gives insight to the fact that commodities are the bundles of factors

(land, labour and capital). Thus, the exchange of commodities is indirect arbitrage of factors

of production and the transfer of services of otherwise immobile factors from regions where

factors are abundant to regions where they are scarce.

A nation exports the commodities which are produced out of its relatively abundant and

cheap factors or resources and imports the commodity which is produced out of relatively

scarce factors or resources. In another words, relatively labour abundant country exports

relatively labour intensive commodity and imports the relatively capital-intensive

commodity.

Assumptions of the Heckscher- Ohlin Model

Heckscher Ohlin mode is based on a number of explicit and implicit assumptions. The

important assumptions of the model are:

1. There are only two nations, with two goods for trade two factors of production

(capital and labour).

2. Both nations use the same technology and they use uniform factors of production.

3. In both countries, good X is labour intensive and Y is capital intensive.

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4. The tastes and preferences of both nations are the same.

5. In both nations, constant returns to scale are applicable for the production of goods.

6. In both nations, there is incomplete specialization in production.

7. Goods and factor markets in both nations are perfectly competitive.

8. There exists perfect mobility of factors of production.

9. There is free flow of international trade. That is, there exist no transportation costs,

tariffs, or like other obstructions either to control or to restrict the exports or imports.

10. There exists full employment of all resources in both nations.

11. The exports and imports between the nations are balanced.

Example:

Imagine two countries Pakistan and USA; each produces both jeans and cell phones by using

the same production technologies: USA has a lot of capital but a limited number of workers,

while the Pakistan has little capital but lots of workers.

USA can produce many cell phones but few pairs of jeans because cell phones are capital

intensive and jeans are labor intensive. Pakistan, on the other hand, can produce many pairs

of jeans but few cell phones.

According to the Heckscher-Ohlin theory, trade makes it possible for each country to

specialize. Each country exports the product the country is most suited to produce in

exchange for products it is less suited to produce. USA specializes in the production of cell

phones, whereas Pakistan specializes in the production of jeans.

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In this case, neither country has specialized in producing more of one of the two particular

products - both countries produce about the same number of jeans and cell phones.

Millions of Jeans Thousands of CellPhones

U.S. -10 +100

Pakistan +10 -30

Total 0 +70

Country A (U.S)- having more capital than labor - has specialized in producing more cell

phones. Country B (Pakistan) - having more labor than capital - has specialized in producing

more jeans. In this case, trade may benefit both countries involved.

Question 3: Discuss main assumptions of Leontif Paradox model and how this model canbe beneficial for international trade.A 195, Leontief tested H-O theory and showed that that pattern of trade did not fit the

conclusions of the H-O theorem. This surprising result is known as Leontief's Paradox.

The test assumed a two factor world which required assumptions about what is capital

and what is labor.

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In this case, neither country has specialized in producing more of one of the two particular

products - both countries produce about the same number of jeans and cell phones.

Millions of Jeans Thousands of CellPhones

U.S. -10 +100

Pakistan +10 -30

Total 0 +70

Country A (U.S)- having more capital than labor - has specialized in producing more cell

phones. Country B (Pakistan) - having more labor than capital - has specialized in producing

more jeans. In this case, trade may benefit both countries involved.

Question 3: Discuss main assumptions of Leontif Paradox model and how this model canbe beneficial for international trade.A 195, Leontief tested H-O theory and showed that that pattern of trade did not fit the

conclusions of the H-O theorem. This surprising result is known as Leontief's Paradox.

The test assumed a two factor world which required assumptions about what is capital

and what is labor.

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In this case, neither country has specialized in producing more of one of the two particular

products - both countries produce about the same number of jeans and cell phones.

Millions of Jeans Thousands of CellPhones

U.S. -10 +100

Pakistan +10 -30

Total 0 +70

Country A (U.S)- having more capital than labor - has specialized in producing more cell

phones. Country B (Pakistan) - having more labor than capital - has specialized in producing

more jeans. In this case, trade may benefit both countries involved.

Question 3: Discuss main assumptions of Leontif Paradox model and how this model canbe beneficial for international trade.A 195, Leontief tested H-O theory and showed that that pattern of trade did not fit the

conclusions of the H-O theorem. This surprising result is known as Leontief's Paradox.

The test assumed a two factor world which required assumptions about what is capital

and what is labor.

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The test assumed consistent technology between nations. However, technology varies

so this assumption may have biased the test.

The test assumed a two factor world which required assumptions about what is capital

and what is labor.

The test assumed consistent technology between nations.

The test assumes perfect mobility between factors of production. In practice, some

factors of production are specific to sectors of the economy. Sector specific factors

alter the predictions of the H-O theory and require a different testing procedure. More

current test of the H-O theory is built on multiple factor (including sector specific

factors) models that extend the basic H-O framework. These show good predictive

ability.

1. It is assumed that human capital is an important ingredient of capital input of a

product, and that it could manifest itself in several ways. Besides knowledge, human

capital should include technological awareness, attitude, intensity, institutional and legal

framework as well.

2. It is assumed that factor-intensity of import- substitutes are used instead of actual imports.

3. It is assumed that capital-abundant country may have not a shortage of some minerals and

other important natural resources. The technologies involved in producing several mineral

products like oil and natural gas are highly capital-intensive. And if they are being

exported by an otherwise labour-abundant country, factor-intensity tests shall reveal a

Leontief Paradox.

4. It is also assumed that trade and tariff policies does not favour capital-intensive imports.

In recent years, US has adopted the stance of discouraging the import of certain goods

produced with sweat labour (that is, labour earning low wages) and from countries

which have poor labour standards.

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5. There is a shared demand between the countries; demand may play a more important role

than comparative advantage as a determinant of trade.

6. There is a product differentiation among the trading countries.

7. Technology may be a substitute of labor; in US there are large agricultural farms that are

managed by heavy machinery and self controlling technology instead of labor.

8. Capital abundant country may be labor intensive as well but it exports surplus labor to

other countries.

The labor and capital intensities of U.S. agricultural trade during 1973, 1974, and 1976 are

examined through an input-output model. The empirical results indicate that U.S. agricultural

exports tend to be more capital intensive while agricultural imports are more labor intensive,

a result counter to Leontief's paradox. Agricultural trade has been increasingly important in

U.S. total trade, but consideration of the factor intensity of agricultural trade has not received

attention commensu rate

with its increasing importance. This paper has specifically addressed the capital and labor

intensities of U.S. agricultural trade and thereby tested the applicability of the Leontief

paradox in U.S. agricultural trade. On the basis of an empirical testing of the model with

three years of trade data we found that the U.S. agricultural exports were more capital-

intensive while agricultural imports were more labor-intensive. This condition is the opposite

of Leontiefs findings. Our finding is also more in line with the expected characteristics of the

U. S. trade given its relative capital and labor endowments. The results of both studies are

easier to accept once one realizes the capital intensiveness (particularly in machinery and

equipment) of U.S. farm production. Those farm subsectors which can best utilize machinery

and equipment capital have been export-oriented and have become increasingly important to

the overall U.S. balance of trade. Perhaps the scarcity of labor in the U.S. relative to other

countries explains our resort to capital-intensive production technologies to compete with

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foreign goods. Recent trade experiences may be signaling this condition. If so, our finding

indicates an important policy implication. That is, to compete with other countries in world

trade, we must reallocate our resources toward producing goods such as agricultural products

which are more capital intensive.

Question 4: Differentiate between tariff and non-tariff barriers. Also analyze theireconomic effects. In your view which one is more effective in order to regulate internationaltrade?Trade barriers are restrictions imposed on movement of goods between countries. Trade

barriers are used to encourage and protect existing domestic industry. Trade barriers have

following economic effect:

i. a reduction effect which is a lowering of overall trade due to the imposition of

barriers,

ii. a compression effect which is a concentration of the source of imports into the largest

iii. a diversion effect which is a shift in trade patterns across exporters

iv. Tariffs increase the prices of imported goods.

v. Government will see increased revenue as imports enter the domestic market

vi. Have direct effect on trade, profit, labor and FDI

The trade barriers can be broadly divided into two broad groups:

1. Tariff Barriers

2. Non-tariff Barriers.

TARIFF BARRIERS

Tariff is a customs duty or a tax on products that move across borders. The main important

tariff barriers are as follows:

1. Specific Duty is a fixed sum of money, keeping in view the weight or measurement

of a commodity. For instance, a fixed sum of duty levied on the import of every

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barrel of oil. By discouraging cheap imports, specific duties are easy to administer.

However, a specific duty cannot be levied on certain articles like works of art. For

instance, a painting cannot be taxed on the basis of its weight and size.

2. Ad valorem Duty is imposed according to value as a fixed percent of value

ignoring the consideration of weight, size or volume of commodity. It is used in case

of those goods whose values cannot be determined on the basis of their physical and

chemical characteristics, such as costly works of art, rare manuscripts, etc.

3. Combined or Compound Duty is a combination of the specific duty and ad valorem

duty on a single product. For instance, there can be a combined duty when 10% of

value (ad valorem) and Re 1/- on every meter of cloth is charged as duty.

4. Sliding Scale Duty varies with the prices of commodities. Also called seasonal duty,

it is confined to agricultural products, as their prices frequently vary, mostly due to

natural factors.

5. Countervailing Duty is imposed on certain imports where products are subsidised by

exporting governments. As a result of government subsidy, imports become cheaper

than domestic goods. To nullify the effect of subsidy, this duty is imposed in addition

to normal duties.

6. Revenue Tariff is designed to provide revenue to the home government, by imposing

duty on consumer goods, luxury goods whose demand from the rich is inelastic.

7. Anti-dumping Duty is imposed to protect exporters attempt to capture foreign

markets by selling goods at rock-bottom prices.

8. Protective Tariff is heavily levied on imports to protect domestic industries from

stiff competition of imported goods. Normally, a very high duty is imposed, so as to

either discourage imports or to make the imports more expensive as that of domestic

products.

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NON-TARIFF BARRIERS

A trade barrier, other than a tariff, that raises an obstacle to free flow of goods in overseas

markets. They do not affect the price of the imported goods, but only the quantity of imports.

Unlike tariffs, non-tariff barriers are often hidden. Sometimes referred to as red tape,Some

of the important non-tariff barriers are as follows:

1. Quota System, where a country may fix in advance, the permitted limit of import

quantity of a commodity from various countries. The quota system can be divided into

the following categories:

Tariff/Customs Quota: Certain specified quantity of imports is allowed at duty free

or at a reduced rate of import duty. Additional imports beyond the specified quantity

are permitted only at increased rate of duty.

Unilateral Quota: The total import quantity is fixed without prior consultations with

the exporting countries.

Bilateral Quota: It is fixed after negotiations between the quota fixing importing

country and the exporting country.

Multilateral Quota: A group of countries can come together and fix quotas for

exports as well as imports for each country.

2. Product Standards: Most developed countries impose product standards, if not me,

the imports are not allowed.

3. Domestic Content Requirements are imposed to boost domestic production. i.e in

the US bailout package, Govt. introduced Buy American Clause.

4. Product Labelling is insisted on the products. For instance, the European Union

insists on product labeling in major languages spoken in EU.

5. Packaging Requirements: Certain nations insist on particular type of packaging i.e

recyclable packing materials; otherwise, the imported goods may be rejected.

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6. Consular Formalities like shipping documents should include consular invoice

certified by their consulate stationed in the exporting country.

7. State Trading, where individual importers or exporters are not allowed to import or

export canalised items directly on their own but through agencies like MMTC.

8. Preferential Arrangements like MFN (Most Favourite Nation) status, whereas other

countries are subject to various tariffs and other regulations.

9. Foreign Exchange Regulations by obtaining a clearance from exchange control

authorities prior to the concluding of contract with the supplier.

10. Other Non-Tariff Barriers such as health and safety regulations, technical

formalities, environmental regulations, embargoes, Import bans,

Complex/discriminatory Rules of Origin, Employment law, State subsidies, Product

classification, Inadequate infrastructure, Over-valued currency.

In practice, tariff barriers are mostly levied on majority of items for the purpose of revenue

generation. Due to the introduction of international organizations designed to improve free

trade, such as the World Trade Organization (WTO), role of tariffs is declining and countries

have shifted to non-tariff barriers. Organizations like the WTO attempt to reduce production

and consumption distortions created by tariffs. These distortions are the result of domestic

producers making goods due to inflated prices, and consumers purchasing fewer goods

because prices have increased.

Question 5: Discuss the application of Product Life Cycle Hypothesis in explainingthe modern trends of international trade. Give examples from Pakistans experience.In response to this changing environment, the manager must have a continuing program to

analyze the future directions of international trade i.e demand biasness and rising income

patterns to introduce new products so that he may plan early enough for appropriate policies.

The product cycle model provides a useful tool in this analysis. The new product will have

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two principal characteristics: (a) it will cater to high-income demands because the United

States is a high-income country; and (b) it promises, in its production process, to be labor-

saving and capital-using in nature. (It is also possible that the product itself

The product life-cycle theory is an economic theory that was developed by Raymond Vernon

in response to the failure of the Heckscher-Ohlin model to explain the observed pattern of

international trade. The theory suggests that early in a product's life-cycle all the parts and

labor associated with that product come from the area in which it was invented. After the

product becomes adopted and used in the world markets, production gradually moves away

from the point of origin. In some situations, the product becomes an item that is imported by

its original country of invention. The model applies to labor-saving and capital-using

products that (at least at first) cater to high-income groups.

The product life-cycle theory is an accurate explanation of international trade patterns.

Consider photocopiers; the product was first developed in the early 1960s by Xerox in the

United States and sold initially to US users. Originally Xerox exported photocopiers from the

United States, primarily to Japan and the advanced countries of Western Europe. As demand

began to grow in those countries, Xerox entered into joint ventures to set up production in

Japan (Fuji-Xerox) and Great Britain (Rank-Xerox). In addition, once Xerox's patents on the

photocopier process expired, other foreign competitors began to enter the market (e.g., Canon

in Japan, Olivetti in Italy). As a consequence, exports from the United States declined, and

US users began to buy some of their photocopiers from lower-cost foreign sources,

particularly from Japan. More recently, Japanese companies have found that manufacturing

costs are too high in their own country, so they have begun to switch production to

developing countries such as Singapore and Thailand. As a result, the United States and

several other advanced countries (e.g., Japan and Great Britain) have switched from being

exporters of photocopiers to being importers. This evolution in the pattern of international

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trade in photocopiers is consistent with the predictions of the product life-cycle theory. The

product life-cycle theory clearly explains the migration of mature industries out of the United

States and into low-cost assembly locations.

There are four stages in a product's life cycle:

(1) Introduction: The product is introduced in the market through a focused and intense

marketing effort designed to establish a clear identity and promote maximum

awareness. Many trial or impulse purchases will occur at this stage. Product is

consumed in producing country only. No international trade takes place.

(2) Growth: Can be recognized by increasing sales and the emergence of competitors. At

the vendor's side, the Growth stage is also characterized by sustained marketing

activities. Some customers make repeat purchases. Mass production techniques start

to be adopted, with more standardization in the production process and economies of

scale start to be realized.

(3) Maturity: This phase can be recognized when competitors beginning to leave the

market. Also, sales velocity is dramatically reduced, and sales volume reaches a

steady level. At this point in time, typically loyal customers purchase the product. In

addition, foreign demand for the product grows, but it is associated particularly with

other developed countries, since the product is catering to high-income demands. This

rise in foreign demand (assisted by economies of scale) leads to a trade pattern

whereby the United States exports the product to other high-income countries.

(4) Decline: The lingering effects of competition, unfavourable economic conditions,

new trends, etc, often explain the decline in sales.

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In the new product stage, the product is produced and consumed in the US; no export trade

occurs. In the maturing product stage, mass-production techniques are developed and foreign

demand (in developed countries) expands; the US now exports the product to other developed

countries. In the standardized product stage, production moves to developing countries,

which then export the product to developed countries. The model demonstrates dynamic

comparative advantage. The country that has the comparative advantage in the production of

the product changes from the innovating (developed) country to the developing countries.

Theory postulates a dynamic comparative advantage because the country source of exports

shifts throughout the life cycle of the product. Early on, the innovating country exports the

good but then it is displaced by other developed countries - which in turn are ultimately

displaced by the developing countries. A casual glance at product history yields this kind of

pattern in a general way.

Example

Prospects of Pakistan based MNE Top quality brands like Olpers, Olwell, Tarang, Omoreand Owsum have been successfully launched under the helm of Engros dairy products. To

support these brands and their highest standards of quality, Engro Foods has invested heavily

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in milk processing and milk collection infrastructure. With an acquisition of Al Safa a fast

growing and established Halal meat brand Engro Foods is now venturing into North

American market starting from Halal Foods category. The new organization, Engro Foods

Canada Ltd. with a subsidiary Engro Foods USA, LLC, intends to aggressively grow the

business in this market. With the vision of Elevating Consumer Delight Worldwide,

Companys significant focus will be towards the global operations in the years to come.

Engro Foods is in stiff competition with the Swiss based Nestle in packaged milk products

and with Walls (Unilever) in ice-cream.

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Question No 1: What is economic integration? Discuss its short run economic effects

for the member and non members in detail. Also discuss the reasons why it is not

successful among the developing countries.

Economic integration refers to agreements between countries in a geographic region to

reduce tariff and non-tariff barriers to the free flow of goods, services, and factors of

production between each other.

Types of regional economic integration:

Preferential trade agreement (PTA) provides lower barriers trade among participating

nations than trade with non member.

Free trade area (EFTA, NAFTA) eliminates all barriers to the trade of goods and

services among member countries. Each member maintains own level & form of

protection against non members.

Customs union (EEC) eliminates trade barriers between member countries and adopts a

common external trade policy consisting on duty-free movement of products/services,

Common external tariff to non members.

A common market has no barriers to trade between member countries, a common

external trade policy, and the free movement of the factors of production for example

MERCOSUR (Brazil, Argentina, Paraguay, and Uruguay) having Supranational

authority for joint economic policy making.

Economic union; EMU has the free flow of products and factors of production between

members, a common external trade policy, common central bank, a common

currency, a harmonized tax rate, and a common monetary and fiscal policy

A political union involves a central political apparatus that coordinates the economic,

social, and foreign policy of member states. EU is headed toward at least partial

political union, and the U.S. is an example of even closer political union.

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Short run effects of Economic Integration

1. Trade creation vs trade diversion

Trade creation higher priced domestic output replaced by lower priced

imports increases welfare

Trade diversion trade diverted from low cost to high cost supplier

decreases welfare

Trade Creation (Positive impact on member countries)

Replacement of domestic expensive goods results in net gain of JCM (Pdn component) AND

BHN (consumption component)

Trade Diversion (Negative impact on Non Member countries)

Lower cost imports from outside the customs union are replaced by higher cost

imports from member unions.

Preferential trade treatment result in the financing of inefficiency within a customs

union.

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Trade diverting customs union results in both trade creation and diversion and

strength depends on the relative strength.

Can increase or reduce welfare of members

Static Welfare effects

CJJ and BHH is the welfare gain from pure trade creation, while MNHJ is the

welfare loss from diverting the initial 30X(JH) of imports from lower cost Nation 1 to

higher cost Nation 3

2. Market extension: Efficient producers enjoy free access to national markets of all

member countries.

3. Temporary unemployment: When inefficient firms exit from the market, workers in

such firms become unemployed. Eventually, they need to move to other industries.

4. Increased Competition

5. Replacement of small national markets with a large supernational market

6. Reaping benefits of economies of scale and learning effects

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7. Increased political cooperation and reduced violent conflict.

Economic Integration among developing countries

The reasons usually mentioned why regional integration is unsuccessful in developing

countries include:

1. Similarity of their economic structure,

2. Uniform market size,

3. Lack of dynamism in their economic development

4. Lack of commitment.

5. Lack of opportunity

6. Lack of opportunity

7. Risk of divergence due to trade diversion

8. Agglomeration effects

9. Economic integration leads to Pareto-reallocation of the factors (labor and capital)

which move towards their better exploitation. Labor moves to area of higher wages,

while capital - to area with higher returns.

10. All countries gain from free trade and investment, regional economic integration is an

attempt to exploit the gains from free trade and investment

11. It implies a loss of national sovereignty

12. It allows firms to realize cost economies by centralizing production in those locations

where the mix of factor costs and skills is optimal

13. Regional economic integration is only beneficial if the amount of trade it creates

exceeds the amount it diverts

14. There is a risk of being shut out of the single market by the creation of a trade

fortress

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Question No 2: What are Multinational Corporations? Why and how they decide to invest

abroad.

Multinational Company (MNC) is a company that is registered and operates in more than

one country at a time. Generally the corporation has its headquarters in one country and

operates wholly or partially owned subsidiaries in other countries. Thus, companies that

have a joint venture abroad, established a foreign subsidiary or acquired an existing operation

in a foreign country are considered MNCs. Madura and Fox, describes three alternatives to

becoming a MNC.

1. A company simply chooses international trade by exporting its goods and/or imports

material or tools. The advantage of international trade is that it is relatively cheap to

pull out, if it turns out not to be profitable.

2. Via licensing a company allows other firms to produce, sell and market its products in

foreign markets.

3. A company chooses to become a franchisor. According to Madura and Fox a franchisor

provides a specialized sale or service strategy, support assistance and possibly an

initial investment in the franchise in exchange for a periodic fee.

Why Multinational Corporations invest abroad

According to OLI model, following three factors that are thought to spike foreign

investments:

Ownership Advantages (O) include low cost advantage, competitive factors,monopolist advantages, privileges like access to scarce natural resources, patent

rights, brand name and advantages from innovation activities like technology,

knowledge broadly give to the international firm the choice to compete abroad

profitably. For example Coca-Cola has significant organizational advantage of

Irfan Arshad 24

trademark that is well-known and enough to sell soft-drinks in numerous countries

across the world.

Locational Advantages (L) include Economic advantages (factors of production,transport and telecommunications costs, scope and size of the market); Political

advantages (Specific government policies that influence FDI, intra-firm trade

and international production); Social, cultural advantages (psychic distance

between the home and host country, language and cultural diversities, general

attitude towards foreigner ant the overall position towards free enterprise) :

Natural resources in Greenland are becoming easier to access.

Internalization Advantages believe that its ownership advantages are bestexploited internally rather than sold directly through spot markets or offered to

other firms through some contractual arrangement such as licensing, the

establishment of a joint venture or management contracting.

There is no proper mechanism that can not directly affect investment decisions of companies

but consideration of following points tend to face less uncertainty and higher expected rates

of return.

1. MNCs try to achieve efficiency by minimizing their cost and maximizing economies

of scale while reducing duplication.

2. They invest in different locations to get different advantages from host countries in

order to operate better in their home base.

3. Multinational companies are looking for the perfect mix of factors of production

including technology.

4. While labour costs and attributes of the workforce such as skill and educational

levels are critical variables of investment decision.

Irfan Arshad 25

5. The purchasing power of the market and proximity to other markets are taken into

consideration in taking the investment decision.

6. The type of investment such as joint venture or wholly owned subsidiaries highly

affects the investment decisions.

7. Market size and growth prospects of the host country, the availability of

infrastructure, reasonable levels of taxation and the overall stability of the tax regime,

stable political environment, as well as conditions that support physical and personal

security, legal framework and the rule of law and corruption and governance concerns

constitute the main concerns of MNCs in taking their decisions in developing

countries.

8. The motivation of MNCs for investing in developed countries differs from that for

investing in developed countries, since the return of investment is higher with its

risk premium. As an example, even though there have been improvements in the

situation, investors face problems with enforcing intellectual property rights and those

selling branded products often have to deal with counterfeits in China, which is the

main destination of MNCs investments.

9. Good governance, Political and commercial factors, the legal framework and rule of

law concepts are of high importance.

How MNEs decide to invest abroad.

As opposed to the existence of uncertainty in different investment environments, MNCs

expanded "and are still expanding "their operations in different parts of the world taking

different advantages of different countries. Similarly developing countries such as Asian

countries, Brazil, Indonesia, and Mexico have realized the impact of FDI on the development

of the country and they have been able to maintain a significant level of FDI inflows taking

Irfan Arshad 26

advantage of their resource factors. In this "race to attract more FDI", countries are trying

to set strategies to attract more FDI for example:

1. Liberalization of investment regimes.

2. Developing strategies in line with the consideration of comparative advantageous areas

i.e Asian countries have relatively low wage rates, Eastern European countries are

focused towards infrastructure enhancement.

3. Fiscal incentives constitute the other type of influential tools to attract FDI. The

incentives such as tax breaks and tax holidays, favourable utility usage fees, reduced

custom duties and foreign exchange restrictions, relaxed ownership controls, and

streamlined administrative procedures aim to create the best place in terms of FDI

attractiveness.

4. Additionally, there has been the development of enclave zones under an overall

national strategy. These zones have been employed "to bring in labour-intensive

manufacturing activities to absorb surplus labour, to experiment with a policy

instrument that has not been used before, and to facilitate the transition from a closed

economy to an open one".

Question No 3: What are the implications of Globalization for Pakistans Trade,

Foreign Direct Investment, and Transfer of Technology.

The phenomenon of globalization is very much multidimentional and it has its direct or

indirect impact in almost all aspects and phases of life which majorly include Economics,

Cultural, and social factors. The source of globalization has made the markets liberal and

has ultimately accelerated and increased the run and pace of globalization in the last two

or three decades. Through the adoption of globalization there are several neighboring

countries of Pakistan which have made them more developed, grown and successful

Irfan Arshad 27

nations amongst which China is on the top and including India and Bangladesh as well.

Pakistan has also shown several positive intentions towards its cause but up till now they

have not shown any drastic change and development. Poverty, in Pakistan, is due to many

factors like literacy rate, infant mortality rate, population growth rate, and access to water

are inextricably tied to the process of globalization, but not in the way one might expect.Globalization has not slowed down Pakistan; rather, it has increased the affluence of itsneighbours, a task that leaves Pakistanclobbered down by protectionist policiesout in thecold. For example, up until 1991, Pakistan was growing at twice the rate of the Indianeconomy. However, that year, India decided to do away with the majority of their remainingtrade barriers, opening up their borders to competitive markets and surpassing Pakistan interms of economic expansion. Pakistan has also been working on this aspect seriously toremove poverty from the country and for that purpose they are also opening their borders forthe foreign trade so that through the positive use of globalization Pakistan can reduce thepoverty which has such negative impacts on the economy of the state. So from the lastseveral years Pakistan is striving to enhance the global trade and for that purpose they havealmost excluded all the non-tariff barriers and the invasion and the arrival of the labor in tothe markets of Pakistan which will ultimately boost up the production and through this theemployment will be generated which will eliminate the poverty from the country.So after such a long isolation from the international and global market Pakistan is also givingthe concessions and the opening of market to the global trade which will enhance andincrease GDP of the country and will help and play the Vital role in reducing and even

eliminating the curse of poverty from the country, so that the economy of Pakistan can be

made stable and developed.

Market Extension: Globalization will lead to promote world trade and extension of markets.

In case of restricted trade a country can sell his products either in his own country or in some

related countries. As a result the, the market of a country remains limited giving rise to low

industrial development, employment and income. Because of globalization a country can sell

Irfan Arshad 28

its surplus goods in many countries. Thus when market is extended the internal and external

economies will be accrued by the firms.

International Economic scenario: The proponents of globalization think that it will promote

mobility of trade, capital and technology. But the facts reveal that technology transfer could

not take place to the desired extent as the multinational companies were having monopoly

over superior technology. They transfer technology for the sake of their interests. The poor

countries could not be provided with capital and financial resources. Their debt burden went

on increasing. The financial and economic crises in ASEAN countries during 1997-98 were

due to such so called globalization. The unemployment and miseries increased. The

globalization created instability and non-competition. This is well evident from the Protests

which were made at the time of international conferences and meetings of world economic

forums.

Access of Technology and Other Information: The globalization will lead to abolish

restrictions on the movement of goods and services. The poor countries of the world are

backward because they lack modern technology, skilled labour force and knowledge.

Therefore when globalization takes place their will be mobility of modern technology, skill

and other information across the borders. The multinational companies of developed

countries will make investment in poor countries. They will bring new technologies. As a

result the process of development will set into motion.

Marshall Mcluham, Canadian theorist propagated the idea of Global Village in 1960.To him

the world has shrunk to a village due to advancement in the fields of science and technology.

Peoples of the world now live in close proximity. Marshall Mcluham, aCanadian theorist

propagated the idea of Global Village in 1960.To him the world has shrunk to a village due to

advancement in the fields of science and technology. Peoples of the world now live in close

proximity.

Irfan Arshad 29

Media revolution has converted the whole world into a global village. Globalizing TV showsand films may influence people, shaping the way they understand their social identities, theircultural communities, and wider world in which they live. Cable TV networks, Electroniccommunication and news.

Question No 4: Define FDI? Discuss with reference to Dunning Theory that how it takes

place? Also discuss why Pakistan has failed to attract FDI in spite of lucrative policies.

Foreign direct investment (FDI) refers to long term participation by a country A into country

B (in this case Pakistan). It usually involves participation in management, joint-venture,

transfer of technology and expertise. There are two types of FDI: inward foreign direct

investment and outward foreign direct investment, resulting in a net FDI inflow (positive or

negative).

Pakistan over the last few years has developed itself as a potential market for foreign

investors with its liberal investment policy, cheap labour, tax incentives and good return on

investments. Following table demonstrates the FDI in Pakistan over the last decade.

Foreign direct investment (FDI): investment in manufacturing and service facilities in

a foreign country.

In recent decades, companies from many countries have expanded into new markets

around the world, thereby adding to the stock of foreign direct investment.

The increase in foreign direct investment has also been promoted by the efforts of

many national governments to woo multinationals.

Portfolio investment or indirect investment refers to investments in foreign countries

that are withdrawable at short notice, such as foreign stocks and bonds.

WHAT ARE THE FOREIGN DIRECT INVESTMENT INCENTIVES IN

PAKISTAN?

The simple answer is that making a direct foreign investment allows companies to

accomplish several tasks:

Irfan Arshad 30

Avoiding foreign government pressure for local production.

Circumventing trade barriers, hidden and otherwise.

Making the move from domestic export sales to a locally-based national sales

office.

Capability to increase total production capacity.

Opportunities for co-production, joint ventures with local partners, joint marketing

arrangements, licensing, etc;

low corporate tax and income tax rates in Pakistan

tax concessions/exemptions to particular businesses

special economic zones developed by the government of pakistan

cheap labour in Pakistan

JOB TRAINING & employment subsidies

Infrastructure subsidies

Research and Development support

Early Entry Advantage.

Pakistan has a very liberal policy on repatriation for foreign direct investors, therefore,

investing in Pakistan may give a foreign direct investors the following added advantages.

Remittance of royalty, technology and franchise fee is allowed to projects in

social, service, infrastructure, agriculture and international chains food franchise.

Minimum share of the local (Pakistani) partner in a joint venture will be 60:40 for

the service sector. However, 100% foreign equity can be owned for first 5 years.

The FBR (Federal Board of Revenue) will not question as to the source of

investment; however, the FBR will only want to know whether the investor has paid

requisite Income Tax on that specific investment. The FBR will not inquire into the

source of the funds.

Irfan Arshad 30

Avoiding foreign government pressure for local production.

Circumventing trade barriers, hidden and otherwise.

Making the move from domestic export sales to a locally-based national sales

office.

Capability to increase total production capacity.

Opportunities for co-production, joint ventures with local partners, joint marketing

arrangements, licensing, etc;

low corporate tax and income tax rates in Pakistan

tax concessions/exemptions to particular businesses

special economic zones developed by the government of pakistan

cheap labour in Pakistan

JOB TRAINING & employment subsidies

Infrastructure subsidies

Research and Development support

Early Entry Advantage.

Pakistan has a very liberal policy on repatriation for foreign direct investors, therefore,

investing in Pakistan may give a foreign direct investors the following added advantages.

Remittance of royalty, technology and franchise fee is allowed to projects in

social, service, infrastructure, agriculture and international chains food franchise.

Minimum share of the local (Pakistani) partner in a joint venture will be 60:40 for

the service sector. However, 100% foreign equity can be owned for first 5 years.

The FBR (Federal Board of Revenue) will not question as to the source of

investment; however, the FBR will only want to know whether the investor has paid

requisite Income Tax on that specific investment. The FBR will not inquire into the

source of the funds.

Irfan Arshad 30

Avoiding foreign government pressure for local production.

Circumventing trade barriers, hidden and otherwise.

Making the move from domestic export sales to a locally-based national sales

office.

Capability to increase total production capacity.

Opportunities for co-production, joint ventures with local partners, joint marketing

arrangements, licensing, etc;

low corporate tax and income tax rates in Pakistan

tax concessions/exemptions to particular businesses

special economic zones developed by the government of pakistan

cheap labour in Pakistan

JOB TRAINING & employment subsidies

Infrastructure subsidies

Research and Development support

Early Entry Advantage.

Pakistan has a very liberal policy on repatriation for foreign direct investors, therefore,

investing in Pakistan may give a foreign direct investors the following added advantages.

Remittance of royalty, technology and franchise fee is allowed to projects in

social, service, infrastructure, agriculture and international chains food franchise.

Minimum share of the local (Pakistani) partner in a joint venture will be 60:40 for

the service sector. However, 100% foreign equity can be owned for first 5 years.

The FBR (Federal Board of Revenue) will not question as to the source of

investment; however, the FBR will only want to know whether the investor has paid

requisite Income Tax on that specific investment. The FBR will not inquire into the

source of the funds.

Irfan Arshad 31

Foreign investors are allowed to invest in industrial project on 100% equity basis

without any permission from the government.

There is no requirement for a No Objection Certificate from the Provincial

Government.

In addition to manufacturing sector foreign investment on a repatriate-able basis is

allowed in services, infrastructure and social sectors.

Full repatriation of capital gains, dividends and profits.

The facility for contracting foreign private loans is available to all those foreign

investors who make investment in the approved sectors.

Foreign controlled manufacturing concerns are allowed to borrow on the domestic

market according to their requirements.

Foreign controlled semi-manufacturing and non-manufacturing concerns can

access loans equal to @ 75% & 50%, respectively, of their paid up capital including

reserves.

BOIs (Board of Investment) approval is not required for foreign companies to

open a bank account.

INVESTMENT POLICY OF GOVERNMENT OF PAKISTAN

For the purposes of foreign investment in Pakistan, the Investment Policy of Pakistan has

formed two broad groupings i.e. manufacturing and non-manufacturing/ service sector.

Salient features of the Pakistan Investment Policy relating to the manufacturing and services

sectors are as follows:

MANUFACTURING SECTOR

The entity must be a company incorporated under the Companies Ordinance, 1984.

100% foreign equity is permissible on the basis of repatriation of capital and

profits (dividend).

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The amount of foreign equity investment must not be less than US $ 0.3 million.

SERVICE SECTOR:

The entity must be a company incorporated under the Companies Ordinance, 1984.

The amount of foreign equity investment must not be less than US $ 0.15 million.

100% foreign equity is permissible on the basis of repatriation of capital and

profits (dividend).

NO GO AREAS (PROHIBITED AREAS)

Government of Pakistan prohibit the following areas for investment:

Arms and ammunition

High explosives

Radioactive substances

Security printing, currency and mint

Alcoholic beverages or liquor

CORPORATE STRUCTURES

Various Corporate structures are available for setting up a place of business in Pakistan for

which Masood and Masood, Corporate and Legal Consultants can give you the optimum

advice putting into prospective the current Pakistan Legislation and the individual

person/companies position.

In terms of the Investment Policy of the Government of Pakistan, there are three (03) ways,

whereby, a foreign company may have its presence in Pakistan.

Liaison Office;

Branch Office; and

Locally incorporated subsidiary

HOW WILL MY FUNDS GET INTO PAKISTAN AND WHAT WILL BE THE EXIT

STRATEGY.

Irfan Arshad 33

State Bank of Pakistan (SBP) regulates remittances in and out of Pakistan under legislature.

There is no restriction on inward remittances by State Bank of Pakistan (SBP) but any

outward remittances whether be royalty, technical fee and dividend have to have a prior

approval from SBP, which the authorising bank/agent would do on the companys behalf.

Similarly any contract for any such remittance needs prior approval of SBP. In case you

require any assistance with the approval from State Bank of Pakistan do let Masood and

Masood know and we will happily complete all the legal paper work and technical

formalities.

WILL A FOREIGN INVESTOR BE TREATED LESS FAVOURABLY ON

INVESTMENT IN PAKISTAN?

Foreign Private Investment (Promotion and Protection) Act, 1976 and the Furtherance and

Protection of Economic Reforms Act, 1992 provide legal cover for protection of foreign

investors/investment in Pakistan.

Furthermore, since Pakistan has entered into Bilateral Agreements on Promotion and

Protection of Investment with more than 46 countries. These Agreements provide the

following:

The Contracting Parties shall encourage investments in their respective territories

by investors of the other Contracting Parties

Non-discrimination between local investors and foreign investors

Equal/non-discriminatory treatment in case of compensation for losses owing to

war, other armed conflicts or a state of national emergency

Free transfer of investments, and income deriving therefrom including profits,

dividends, interest income, proceeds of sales or liquidation, repayments of loans,

salaries, wages and other compensation, etc.

Irfan Arshad 34

A dispute settlement mechanism to settle any dispute between the countries with

respect to the interpretation of the respective agreement and a dispute settlement

procedure to settle any dispute between a host country and an investor of the other

country

DOES MASOOD AND MASOOD HAVE EXPERIENCE IN HANDLING FOREIGN

CLIENTS?

Yes, we have successfully managed to assist many multinationals and foreign individuals to

invest in Pakistan and form a place of business to that effect. Masood and Masood is

currently dealing with various foreign direct investment projects in Pakistan including, but

not limited to, the following:

Real estate projects

Power projects

Oil and gas related projects

Development projects

Construction projects

IT related projects

Various manufacturing projects

Service related projects

Non-manufacturing projects

Health related projects

Cosmetics & toiletries related projects

Irfan Arshad 35

Question No 5: Differentiate between fixed and floating exchange rates. Also discuss

their merits and demerits.