Country A can produce both cloth and wheat with fewer resources than Country B. According to Ricardo, trade between them:

Can still benefit both, because comparative advantage rests on opportunity cost

Benefits only Country A, which is more efficient in both goods

Cannot occur, because Country B has no absolute advantage

Benefits both only if their wage rates are equal

Which of the following is a non-tariff barrier?

A local content requirement on assembled goods

An ad valorem duty of ten per cent on imports

A specific duty of ₹50 per kilogram

A compound duty combining both of the above forms

The essential distinction between foreign direct investment and foreign portfolio investment is:

Whether the investor seeks an effective voice in management

The absolute size of the sum invested

Whether the investment is routed through a bank

Whether the investor is an individual or an institution

A customs union differs from a free trade area in that it additionally provides for:

A common external tariff against non-members

Free movement of labour between members

A single currency for all members

The removal of tariffs between members

After joining a preferential bloc, a country replaces imports from a low-cost non-member with dearer imports from a member. This is:

Trade diversion, which reduces welfare

Trade creation, which raises welfare

An improvement in the terms of trade

Remittances received from citizens working abroad are recorded in the balance of payments under:

The current account, as secondary income

The capital account, as an inflow of capital

Errors and omissions, being unmeasurable

The reserve account, alongside foreign exchange reserves

Which institution provides long-term project and development finance?

The International Monetary Fund

International Business: Trade, Investment and the Institutions

The second half of Unit 1 moves from the firm's domestic environment to the world it sells into. The syllabus lists six blocks — scope and globalization, modes of entry, theories of trade and barriers to it, FDI and FPI, the balance of payments, and regional and multilateral institutions — and the examiner works mostly by contrast: FDI against FPI, tariff against non-tariff, trade creation against trade diversion, a customs union against a common market. This chapter is organised around those contrasts, because getting the pair right is what earns the mark.

1. Globalization and the modes of entry

The drivers of globalization the syllabus expects are falling trade barriers, falling transport and communication costs, convergence of consumer preferences, and the spread of production across borders. What follows from them for a firm is a menu of ways to enter a foreign market, ordered by how much of the firm's own capital and control goes with it.

Entry modes by commitment and control
Mode	Capital committed	Control	Chief risk
Exporting, direct or indirect	Least	Low over the local market	Tariffs and distance
Licensing and franchising	Low	Limited by contract	Creating a competitor from the licensee
Joint venture	Shared	Shared	Disagreement with the partner
Wholly owned subsidiary	Greatest	Complete	Full exposure to political and market risk

🎯 Why the order is a trade-off, not a ladder

Firms are often described as climbing from exporting to subsidiaries as they learn a market, and many do. But the choice is a trade-off between control and exposure, so a firm facing high political risk may stop at licensing permanently and be right to. Treating the list as a sequence every firm must complete is a misreading.

2. Theories of trade, and the barriers governments raise against it

Mercantilism — a nation gains by exporting more than it imports and accumulating bullion. Treats trade as zero-sum, which is exactly what the later theories deny.
Absolute advantage (Adam Smith) — each country should produce what it makes with fewer resources than anyone else and trade for the rest.
Comparative advantage (Ricardo) — trade still benefits both even when one country is better at everything, because what matters is the opportunity cost of one good in terms of the other. This is the single most examined idea in the block.
Heckscher-Ohlin — a country exports the good that uses intensively the factor it has in abundance, so a labour-abundant country exports labour-intensive goods.
Product life cycle (Vernon) — a product is first made and sold in the innovating country, then exported, then produced abroad, and eventually imported back.

⚠️ Absolute is not comparative

A country with an absolute advantage in both goods still has a comparative advantage in only one, because comparative advantage is measured in opportunity cost and the two opportunity costs cannot both be lower. Any question that says 'better at producing both' is testing this and the answer is that trade still benefits both parties.

Against this, governments intervene. A tariff is a tax on an imported good and raises revenue while raising its price; a non-tariff barrier restricts the quantity or the conditions instead. Import quotas, licensing, local content requirements, voluntary export restraints, anti-dumping duties, and technical or sanitary standards are all non-tariff. The examinable consequence is that a tariff yields revenue to the government whereas a quota yields the same price rise to whoever holds the quota rent.

3. FDI and FPI, and why the distinction is not about size

Foreign direct investment is investment made with the object of a lasting interest and an effective voice in the management of an enterprise abroad. Foreign portfolio investment is the purchase of financial assets for a return, with no intention of control. The line is drawn by control, not by amount, although a ten per cent equity holding is the conventional statistical threshold.

The two flows contrasted
Dimension	FDI	FPI
Intent	Lasting interest and management voice	Financial return only
Horizon	Long, hard to reverse	Short, exits quickly
Brings with it	Technology, management practice, market access	Capital, and liquidity to the securities market
Risk to the host	Crowding out local firms, transfer pricing, profit repatriation	Sudden reversal destabilising the currency

FDI is classified in two further ways the syllabus expects. By direction it is horizontal when the same activity is replicated abroad, vertical when a stage of the supply chain is placed abroad, and conglomerate when the activity is unrelated. By route into India it is automatic where no prior approval is needed, or government where approval is.

4. Balance of payments: what balances and what does not

The balance of payments is the record of all economic transactions between residents of a country and the rest of the world over a period. It is kept by double entry, so the account as a whole always balances; what can be in surplus or deficit is a component of it.

Current account — merchandise trade, services, primary income such as investment income, and secondary income such as remittances. India characteristically runs a merchandise deficit offset in part by a services surplus and remittances.
Capital and financial account — foreign investment, loans, banking capital and the change in reserves. A current account deficit must be financed here.
Errors and omissions — the balancing residual that absorbs measurement error, which is why the recorded accounts do not sum exactly without it.

⚠️ Balance of trade is not balance of payments

The balance of trade is merchandise exports minus merchandise imports — one line inside the current account. A country can run a trade deficit and a current account surplus at once if its services and remittances are large enough. Questions exploit the two names being close.

5. Regional integration and the multilateral institutions

Regional economic integration is graded by how much sovereignty the members pool, and the ladder is fixed. Each rung adds one thing to the rung below it.

The levels of integration
Level	What it adds	Example
Free trade area	Internal tariffs removed; each member keeps its own external tariff	NAFTA
Customs union	A common external tariff as well	Mercosur
Common market	Free movement of labour and capital as well	The European Economic Community
Economic union	Harmonised economic policy, often a single currency	The European Union

Viner's distinction decides whether such a bloc helps. Trade creation is the replacement of a member's costly home production by a cheaper partner's, which raises welfare. Trade diversion is the replacement of a cheaper non-member's exports by a dearer partner's, purely because the partner now faces no tariff, which lowers it. A preferential bloc is beneficial on balance only when creation outweighs diversion.

IMF — short-term balance of payments support and exchange rate surveillance. Not a development lender.
World Bank — long-term project and development finance, through the IBRD and IDA.
UNCTAD — a United Nations body for trade and development, and a forum rather than a lender.
WTO — successor to the GATT since 1995; administers the agreements, and uniquely has a binding dispute settlement mechanism. Its named agreements in the syllabus are the Agreement on Agriculture, GATS on services, TRIPS on intellectual property and TRIMS on investment measures.

🧠 Which institution, in one question

Ask what the money or the rule is for. Short-term and to stabilise a currency, it is the IMF. Long-term and to build something, it is the World Bank. No money at all, only a rule and a dispute, it is the WTO. A report and a conference, it is UNCTAD.

Key takeaways

Entry modes trade control against exposure: exporting risks least and controls least, a wholly owned subsidiary the reverse. The list is a trade-off, not a sequence every firm must finish.
Comparative advantage, not absolute, is what makes trade mutually beneficial: opportunity costs cannot both be lower, so a country better at everything still gains by specialising.
FDI and FPI are separated by control and horizon, not amount; a tariff differs from a quota in who collects the price rise — the government or the quota holder.
The balance of payments always balances; the balance of trade is one line inside its current account, and a country may run a trade deficit with a current account surplus.
The integration ladder is fixed — free trade area, customs union, common market, economic union — and a bloc helps only when trade creation outweighs trade diversion.

Practice questions (9)

Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.

Country A can produce both cloth and wheat with fewer resources than Country B. According to Ricardo, trade between them:
1. Can still benefit both, because comparative advantage rests on opportunity cost
2. Benefits only Country A, which is more efficient in both goods
3. Cannot occur, because Country B has no absolute advantage
4. Benefits both only if their wage rates are equal
Show answer
Answer: A — Can still benefit both, because comparative advantage rests on opportunity cost
Ricardo's contribution was to show that absolute advantage is not the test. Comparative advantage compares the opportunity cost of one good in terms of the other, and those two opportunity costs cannot both be lower in the same country — if A gives up less wheat per unit of cloth, it necessarily gives up more cloth per unit of wheat. So each country has a comparative advantage in one good and both gain by specialising and trading. The argument does not depend on equal wages, and the claim that trade cannot occur is Smith's absolute-advantage reasoning, which Ricardo superseded.
Which of the following is a non-tariff barrier?
1. A local content requirement on assembled goods
2. An ad valorem duty of ten per cent on imports
3. A specific duty of ₹50 per kilogram
4. A compound duty combining both of the above forms
Show answer
Answer: A — A local content requirement on assembled goods
A local content requirement obliges a producer to source a stated proportion of inputs domestically. It restricts trade without levying a tax at the border, which is the defining feature of a non-tariff barrier. The other three are all tariffs, differing only in how the rate is expressed: ad valorem as a percentage of value, specific as an amount per physical unit, and compound as a combination. Quotas, licensing, voluntary export restraints, anti-dumping measures and technical standards belong with the first option.
The essential distinction between foreign direct investment and foreign portfolio investment is:
1. Whether the investor seeks an effective voice in management
2. The absolute size of the sum invested
3. Whether the investment is routed through a bank
4. Whether the investor is an individual or an institution
Show answer
Answer: A — Whether the investor seeks an effective voice in management
Direct investment is defined by a lasting interest and an effective voice in the management of the enterprise; portfolio investment is the purchase of financial assets for a return with no such intention. A ten per cent equity holding is the conventional statistical threshold used to classify flows, but the underlying criterion is control rather than amount. A very large portfolio holding remains portfolio investment, and a small but controlling stake in a closely held firm is direct investment, which is why size, routing and the investor's legal form are all irrelevant here.
A customs union differs from a free trade area in that it additionally provides for:
1. A common external tariff against non-members
2. Free movement of labour between members
3. A single currency for all members
4. The removal of tariffs between members
Show answer
Answer: A — A common external tariff against non-members
The ladder of integration adds exactly one feature at each rung. A free trade area removes internal tariffs while each member keeps its own tariff schedule against the outside world; a customs union adds a common external tariff. Free movement of labour and capital belongs to the next rung, the common market, and a single currency to the economic union above that. The removal of internal tariffs is what the free trade area already does, so it cannot be the difference between the two.
After joining a preferential bloc, a country replaces imports from a low-cost non-member with dearer imports from a member. This is:
1. Trade diversion, which reduces welfare
2. Trade creation, which raises welfare
3. Dumping by the member country
4. An improvement in the terms of trade
Show answer
Answer: A — Trade diversion, which reduces welfare
Viner separated the two effects of a preferential bloc. Trade creation occurs when a member's own costly production is replaced by a cheaper partner's, shifting output to the efficient producer and raising welfare. Trade diversion occurs when a cheaper non-member's exports are displaced by a dearer partner's, purely because the partner no longer faces the tariff, shifting output away from the efficient producer and lowering welfare. The situation described is the second. Dumping means selling below normal value and is not what has happened here.
Which WTO agreement governs trade in services?
1. GATS
2. TRIPS
3. TRIMS
4. The Agreement on Agriculture
Show answer
Answer: A — GATS
The General Agreement on Trade in Services extends multilateral disciplines to services, which the original GATT covered only in goods. TRIPS deals with trade-related aspects of intellectual property rights such as patents, trademarks and copyright; TRIMS deals with trade-related investment measures such as local content and trade-balancing requirements; and the Agreement on Agriculture covers market access, domestic support and export subsidies in agriculture. All four are named in the syllabus and are routinely tested by matching the acronym to its subject matter.
Remittances received from citizens working abroad are recorded in the balance of payments under:
1. The current account, as secondary income
2. The capital account, as an inflow of capital
3. Errors and omissions, being unmeasurable
4. The reserve account, alongside foreign exchange reserves
Show answer
Answer: A — The current account, as secondary income
The current account has four components: merchandise trade, services, primary income such as investment income and compensation of employees, and secondary income, which is transfers made without a quid pro quo. Remittances are transfers of exactly that kind and belong to secondary income. They are not capital account items because nothing is acquired or owed in return, and they are measured rather than left to errors and omissions. For India they are a substantial offset to the merchandise trade deficit.
Which institution provides long-term project and development finance?
1. The World Bank
2. The International Monetary Fund
3. UNCTAD
4. The World Trade Organisation
Show answer
Answer: A — The World Bank
The World Bank lends long term for projects and development through the IBRD and, on concessional terms, the IDA. The International Monetary Fund is the short-term institution: it supports a member facing a balance of payments difficulty and conducts exchange rate surveillance, and it is not a development lender. UNCTAD is a United Nations forum for trade and development that produces analysis rather than finance, and the World Trade Organisation administers trade agreements and settles disputes without lending at all.
A manufacturer sets up a plant abroad to produce the same product it already makes at home. This FDI is best described as:
1. Horizontal FDI
2. Vertical FDI
3. Conglomerate FDI
4. Portfolio investment
Show answer
Answer: A — Horizontal FDI
Horizontal FDI replicates the same stage of the same activity in another country, typically to serve that market directly rather than by exporting to it. Vertical FDI places a different stage of the supply chain abroad, such as a components plant feeding a home assembly line or a distribution arm selling the home output. Conglomerate FDI is investment in an activity unrelated to the firm's existing business. Portfolio investment is excluded because a plant built and operated by the firm carries control by definition.