Q.1 What is globalization? What are its benefits?

How does globalization help in

international business? Give some instances

What is Globalization?

Economic "globalization" is a historical process, the result of human innovation and

technological progress. It refers to the increasing integration of economies around the world,
particularly through trade and financial flows. The term sometimes also refers to the movement
of people (labor) and knowledge (technology) across international borders. There are also
broader cultural, political and environmental dimensions of globalization that are not covered
here.

At its most basic, there is nothing mysterious about globalization. The term has come into
common usage since the 1980s, reflecting technological advances that have made it easier and
quicker to complete international transactions – both trade and financial flows. It refers to an
extension beyond national borders of the same market forces that have operated for centuries at
all levels of human economic activity – village markets, urban industries, or financial centers.

Markets promote efficiency through competition and the division of

labor – the specialization that allows people and economies to focus on what they do best. Global
markets offer greater opportunity for people to tap into more and larger markets around the
world. It means that they can have access to more capital flows, technology, cheaper imports,
and larger export markets. But markets do not necessarily ensure that the benefits of increased
efficiency are shared by all. Countries must be prepared to embrace the policies needed, and in
the case of the poorest countries may need the support of the international community as they do
so.

Unparalleled Growth, Increased Inequality: 20th Century Income Trends

Globalization is not just a recent phenomenon. Some analysts have argued that the world
economy was just as globalized 100 years ago as it is today. But today commerce and financial
services are far more developed and deeply integrated than they were at that time. The most
striking aspect of this has been the integration of financial markets made possible by modern
electronic communication.

The 20th century saw unparalleled economic growth, with global per capita GDP increasing
almost five-fold. But this growth was not steady – the strongest expansion came during the
second half of the century, a period of rapid trade expansion accompanied by trade – and
typically somewhat later, financial – liberalization. Chart 1 break the century into four periods.
In the inter-war era, the world turned its back on internationalism – or globalization as we now
call it – and countries retreated into closed economies, protectionism and pervasive capital
controls. This was a major factor in the devastation of this period, when per capita income
growth fell to less than 1 percent during 1913-1950. For the rest of the century, even though
population grew at an unprecedented pace, per capita income growth was over 2 percent, the
fastest pace of all coming during the post – World War boom in the industrial countries.
The story of the 20th century was of remarkable average income growth, but it is also quite
obvious that the progress was not evenly dispersed. The gaps between rich and poor countries,
and rich and poor people within countries, have grown. The richest quarter of the world’s
population saw its per capita GDP increase nearly six-fold during the century, while the poorest
quarter experienced less than a three-fold increase (Chart 1). Income inequality has clearly
increased. But, as noted below, per capita GDP does not tell the whole story.

1.2.3 Developing countries: How deeply integrated?

Globalization means that world trade and financial markets are becoming more integrated. But
just how far have developing countries been involved in this integration? Their experience in
catching up with the advanced economies has been mixed. Chart 2 shows that in some countries,
especially in Asia, per capita incomes have been moving quickly toward levels in the industrial
countries since 1970. A larger number of developing countries have made only slow progress or
have lost ground. In particular, per capita incomes in Africa have declined relative to the
industrial countries and in some countries have declined in absolute terms. Chart 2b illustrates
part of the explanation: the countries catching up are those where trade has grown strongly.

Consider four aspects of globalization:

· Trade: Developing countries as a whole have increased their share of world trade – from 19
percent in 1971 to 29 percent in 1999. But Chart 2b shows great variation among the major
regions. For instance, the newly industrialized economies (NIEs) of Asia have done well, while
Africa as a whole has fared poorly. The composition of what countries export is also important.
The strongest rise by far has been in the export of manufactured goods. The share of primary
commodities in world exports – such as food and raw materials – that are often produced by the
poorest countries, has declined.

· Capital movements: Chart 3 depicts what many people associate with globalization, sharply
increased private capital flows to developing countries during much of the 1990s. It also shows
that:

· the increase followed a particularly "dry" period in the 1980s;

· net official flows of "aid" or development assistance have fallen significantly since the early
1980s; and

· the composition of private flows has changed dramatically. Direct foreign investment has
become the most important category. Both portfolio investment and bank credit rose but they
have been more volatile, falling sharply in the wake of the financial crises of the late 1990s.

· Movement of people: Workers move from one country to another partly to find better
employment opportunities. The numbers involved are still quite small, but in the period 1965-90,
the proportion of labor forces round the world that was foreign born increased by about one-half.
Most migration occurs between developing countries. But the flow of migrants to advanced
economies is likely to provide a means through which global wages converge. There is also the
potential for skills to be transferred back to the developing countries and for wages in those
countries to rise.

· Spread of knowledge (and technology): Information exchange is an integral, often

overlooked, aspect of globalization. For instance, direct foreign investment brings not only an
expansion of the physical capital stock, but also technical innovation. More generally,
knowledge about production methods, management techniques, export markets and economic
policies is available at very low cost, and it represents a highly valuable resource for the
developing countries.

The special case of the economies in transition from planned to market economies – they too are
becoming more integrated with the global economy – is not explored in much depth here. In fact,
the term "transition economy" is losing its usefulness. Some countries (e.g. Poland, Hungary) are
converging quite rapidly toward the structure and performance of advanced economies. Others
(such as most countries of the former Soviet Union) face long – term structural and institutional
issues similar to those faced by developing countries.

Chart 1
Q.2 What is culture and in the context of international business environment how
does it impact international business decisions?

Q.3 Explain the meaning of the term ‘trade liberalization’ and advantages. Also,
identify some commonly observed mistakes in international trade.

Policies that make an economy open to trade and investment with the rest of the world are
needed for sustained economic growth. The evidence on this is clear. No country in recent
decades has achieved economic success, in terms of substantial increases in living standards for
its people, without being open to the rest of the world. In contrast, trade opening (along with
opening to foreign direct investment) has been an important element in the economic success of
East Asia, where the average import tariff has fallen from 30 percent to 10 percent over the past
20 years.

Opening up their economies to the global economy has been essential in enabling many
developing countries to develop competitive advantages in the manufacture of certain products.
In these countries, defined by the World Bank as the "new globalizers," the number of people in
absolute poverty declined by over 120 million (14 percent) between 1993 and 1998.

There is considerable evidence that more outward-oriented countries tend consistently to grow
faster than ones that are inward-looking. Indeed, one finding is that the benefits of trade
liberalization can exceed the costs by more than a factor of 10. Countries that have opened their
economies in recent years, including India, Vietnam, and Uganda, have experienced faster
growth and more poverty reduction. On average, those developing countries that lowered tariffs
sharply in the 1980s grew more quickly in the 1990s than those that did not.

Freeing trade frequently benefits the poor especially. Developing countries can ill-afford the
large implicit subsidies, often channeled to narrow privileged interests that trade protection
provides. Moreover, the increased growth that results from free trade itself tends to increase the
incomes of the poor in roughly the same proportion as those of the population as a whole. New
jobs are created for unskilled workers, raising them into the middle class. Overall, inequality
among countries has been on the decline since 1990, reflecting more rapid economic growth in
developing countries, in part the result of trade liberalization.

The potential gains from eliminating remaining trade barriers are considerable. Estimate of the
gains from eliminating all barriers to merchandise trade range from US$250 billion to US$680
billion per year. About two-thirds of these gains would accrue to industrial countries. But the
amount accruing to developing countries would still be more than twice the level of aid they
currently receive. Moreover, developing countries would gain more from global trade
liberalization as a percentage of their GDP than industrial countries, because their economies are
more highly protected and because they face higher barriers.

Although there are benefits from improved access to other countries’ markets, countries benefit
most from liberalizing their own markets. The main benefits for industrial countries would come
from the liberalization of their agricultural markets. Developing countries would gain about
equally from liberalization of manufacturing and agriculture. The group of low-income
countries, however, would gain most from agricultural liberalization in industrial countries
because of the greater relative importance of agriculture in their economies.

3.4 The Need for Further Liberalization of International Trade

These considerations point to the need to liberalize trade further. Although protection has
declined substantially over the past three decades, it remains significant in both industrial and
developing countries, particularly in areas such as agriculture products or labour-intensive
manufactures and services (e.g., construction), where developing countries have comparative
advantage.

Industrial countries maintain high protection in agriculture through an array of very high tariffs,
including tariff peaks (tariffs above 15 percent), tariff escalation (tariffs that increase with the
level of processing), and restrictive tariff quotas (limits on the amount that can be imported at a
lower tariff rate). Average tariff protection in agriculture is about nine times higher than in
manufacturing. In addition, agricultural subsidies in industrial countries, which are equivalent to
2/3 of Africa’s total GDP, undermine developing countries’ agricultural sectors and exports by
depressing world prices and pre-empting markets. For example, the European Commission is
spending 2.7 billion euro per year making sugar profitable for European farmers at the same time
that it is shutting out low-cost imports of tropical sugar.

In industrial countries, protection of manufacturing is generally low, but it remains high on many
labour-intensive products produced by developing countries. For example, the United States,
which has an average import tariff of only 5 percent, has tariff peaks on almost 300 individual
products. These are largely on textiles and clothing, which account for 90 percent of the $1
billion annually in U.S. imports from the poorest countries – a figure that is held down by import
quotas as well as tariffs. Other labour-intensive manufactures are also disproportionately subject
to tariff peaks and tariff escalation, which inhibit the diversification of exports toward higher
value – added products.

Many developing countries themselves have high tariffs. On average, their tariffs on the
industrial products they import are three to four times as high as those of industrial countries, and
they exhibit the same characteristics of tariff peaks and escalation. Tariffs on agriculture are even
higher
(18 percent) than those on industrial products.

Non-traditional measures to impede trade are harder to quantify and assess, but they are
becoming more significant as traditional tariff protection and such barriers as import quotas
decline. Antidumping measures are on the rise in both industrial and developing countries, but
are faced disproportionately by developing countries. Regulations requiring imports to conform
to technical and sanitary standards comprise another important hurdle. They impose costs on
exporters that can exceed the benefits to consumers. European Union regulations on aflotoxins,
for example, are costing Africa $1.3 billion in exports of cereals, dried fruits, and nuts per
European life saved. Is this an appropriate balance of costs and benefits?
For a variety of reasons, preferential access schemes for poorer countries have not proven very
effective at increasing market access for these countries. Such schemes often exclude, or provide
less generous benefits for, the highly protected products of most interest to exporters in the
poorest countries. They are often complex, non-transparent, and subject to various exemptions
and conditions (including non-economic ones) that limit benefits or terminate them once
significant market access is achieved.

Further liberalization – by both industrial and developing countries – will be needed to realize
trade’s potential as a driving force for economic growth and development. Greater efforts by
industrial countries and the international community more broadly, are called for to remove the
trade barriers facing developing countries, particularly the poorest countries. Although quotas
under the so-called Multi-fibre Agreement are due to be phased out by 2005, speedier
liberalization of textiles and clothing and of agriculture is particularly important. Similarly, the
elimination of tariff peaks and escalation in agriculture and manufacturing also needs to be
pursued. In turn, developing countries would strengthen their own economies (and their trading
partners’) if they made a sustained effort to reduce their own trade barriers further.

Enhanced market access for the poorest developing countries would provide them with the
means to harness trade for development and poverty reduction. Offering the poorest countries
duty – and quota – free access to world markets would greatly benefit these countries at little
cost to the rest of the world. The recent market-opening initiatives of the EU and some other
countries are important steps in this regard. To be completely effective, such access should be
made permanent, extended to all goods, and accompanied by simple, transparent rules of origin.
This would give the poorest countries the confidence to persist with difficult domestic reforms
and ensure effective use of debt relief and aid flows.

Some Common Mistakes in International Trade

Common Export Mistakes Solutions

1. Failure to obtain qualified export Obtain Export Counselling
counselling and to develop a master
international marketing plan before
starting an export business.
2. Insufficient commitment by top Determine Export Readiness
management to exporting.
3. Failure to have a solid Understand Agent/Distributor
agent/distributor’s agreement Contracts
4. Blindly chasing “E-orders” from Avoid Accidental Exporting
around the world.
5. Failure to understand the connection Understand Export Financing

between country risk and securing

export financing.
6. Failure to understand Intellectual Understand Intellectual Property
Property Rights Rights (IPR)
7. Insufficient attention to marketing Pay Attention to Overseas Marketing
and advertising requirements. and Advertising
8. Lack of attention to product Pay Attention to Product Preparation
preparation needs. Requirements
9. Failure to consider legal aspects of Understand Licensing and Joint
going global. Ventures
10. Failure to know the rules of trade. Understand Export Regulations
· Failure to obtain export counselling and to develop a master international marketing plan before starting an export business:

Utilize Government and Association Resources for Export Counselling: It is also important for
new exporters to seek legal counsel.

Hire a Lawyer to Help. You Structure Your Export Operations for the Long Run: Lawyers are
concerned with issues of compliance on both ends of the transaction, therefore they are
instrumental in helping you to make sure that your recordkeeping system is planned correctly,
that your legal documents are structured correctly, and to advise you on a broad range of
compliance issues before the sale, during the sale, and after the sale.

· Insufficient commitment to overcome the initial difficulties and financial requirements of

exporting:

To be successful in exporting, firms have to establish an export department to which they

dedicate personnel and a budget, and for which they develop appropriate procedures, preferably
in consultation with a qualified trade lawyer.
· Failure to have a solid agent and or distributor’s agreement:

Firms that intend to enter and to expand in exporting will likely need an agent or distributor at
some point. Key considerations include

Understanding the Role of Agents: The NTDB Web site at (www.stat-USA.gov) provides
information on agents and distributors. As explained on this Web site, agents receive
commission on their sales rather than buying and selling for their own account. As agents do not
own the products they sell, the risk of loss remains with the company the agent represents (the
principal).

Understanding the Role of Distributors: The key legal distinctions between an agent and
distributor are

• A distributor takes title to the goods and accepts the risk of loss. A distributor makes
profits by reselling the goods.
• Distributors cannot contractually bind the company producing the goods.
• Distributors establish the price and sales terms of the goods.

Contract Drafting Considerations for Agent/Distributor Agreements: The first and most
important consideration when drafting an agreement is to, ensure that the agreement clearly
states whether there is an agent or a distributor relationship. The agreement should also clarify
the terms and conditions for selling the products. For example:

• Determine whether the relationship is exclusive versus non-exclusive.

• Specify which geographic regions are to be covered.
• Outline issues of payment and payment schedules for the products (in the case of a
distributor) and for payments of commissions (in the case of agents).
• Determine the currency in which payments are to be made and address currency
fluctuation issues.
• Provide specific provisions regarding renewal of the agreement, including specific
parameters for performance, promotional activity and notice of desire to renew.
• Establish a specific provision for termination of the agreement and terms for such
termination. (Some foreign countries restrict or prohibit termination without just cause or
compensation.)
• Outline the termination process for the end of the agreement period.
• Provide for workable and acceptable dispute settlement clauses.
• Assure that the agreement addresses whether or not intellectual property rights are being
licensed or reserved.
• Do not allow, without seller’s consent, the contract to be assigned to another party (sub-
agents or sub-distributors) to be used to fulfil obligations in the contract or the contract to
be transferred with a change of ownership or control over the agent/distributor.
• Assure that your contract complies with both U.S. and foreign laws.

· Blindly chasing orders from around the world

You may be in your office when suddenly and unexpectedly someone from a foreign country
contacts you electronically and wants to buy a line of your products. What do you do next?

Make sure the order is not on the denied list: Go to the Bureau of Industry and Security’s Web
site to view the entire list of denied orders (bxa.doc.gov/DPL/Default.shtm).

Business considerations in checking out the firm making the inquiry: Make sure the opportunity
is a reasonable one and involves something that can reasonably be handled by your firm, without
spending countless hours researching the requirement. The Department of Commerce
Commercial Service has a number of services to assist you.

• International Company Profile (ICP) – The ICP service, referred to earlier, helps firms
investigate the reliability of prospective trading partners.
• Country Directories of International Contacts (CDIC) Provides the name and contact
information for directories of importers, agents, trade associations, government agencies,
etc., on a country-by-country basis. The information is available on the National Trade
Data Bank.

Competitive considerations in checking out the market for the product: By reviewing industry
sector information, firms can obtain useful data to assess the probability that the inquiry they are
investigating is real. One resource that may be helpful is the Department of Commerce,
Commercial Service’s Industry Sector.

· Failure to understand the connection between country risk and the probability of getting
export financing

The best source of information about whether a country is in good standing with the U.S. is the
U.S. Export-Import Bank’s Country Limitation Schedule. (www.exim.gov).

Access the Export Financing Options: The SBA, ExIm and the Agriculture Department are three
of the biggest providers of export financing in the federal government. A list of the strategic
banking partners of the ExIm and SBA export financing and credit insurance programs can be
obtained from ExIm and SBA.

Check out SBA’s Export Financing Products: The SBA’s Export Working Capital Program
(EWCP) provides short-term working capital for up to one year.

Consult the ExIm’s Export Financing Products: The ExIm’s Working Capital Guarantee
Program allows commercial lenders to make working capital loans to U.S. exporters for various
export-related activities by substantially reducing the risks associated with these loans.

Access ExIm’s Export Credit Insurance: The Export Credit Insurance program provides
protection against losses associated with foreign buyers or other foreign debtor default for
political or commercial reasons.

· Failure to understand Intellectual Property Rights (IPR):

Intellectual property rights refer to the legal system that protects patents, trademarks, copyrights,
trade secrets. It is important for exporters to understand how and whether intellectual property
rights are protected in different countries.

· Insufficient attention to marketing and advertising requirements:

Key considerations include

Trade Shows and Trade Missions: Trade shows and missions may be in the virtual form or
entail travelling to the foreign country.

Advertising: Exporters can advertise U.S.-made products or services in Commercial News USA,
a catalogue-magazine published 10 times a year to promote U.S. products and services in
overseas markets. Commercial News USA is disseminated to business readers worldwide via
U.S. embassies and consulates and international electronic bulletin boards, and selected portions
are also reprinted in certain newsletters.
U.S. Pavilions: About eighty to one hundred worldwide trade fairs are selected annually by the
Commerce Department for recruitment of a USA pavilion. Selection priority is given to events in
viable markets that are suitable for new-to-export or new-to-market, "export ready" firms.
· Lack of attention to product adaptation and preparation needs

The selection and preparation of a firm’s product for export requires not only knowledge of the
product, but also knowledge of the unique characteristics of each market being targeted. Key
considerations include

Product Adaptation to standards requirements: As tariff barriers (tariffs, duties, and quotas)
are eliminated around the world in accordance with the requirements of participation in the
World Trade Organization (WTO), other non-tariff barriers, such as product standards, are
proliferating. Exporters must understand conformity requirements to operate on an international
basis. The DOC’s National Center for Standards and Certification Information (NCSCI) provides
information on U.S. and foreign conformity assessment procedures and standards for non-
agricultural products. You can visit their Web site by going to ts.nist.gov.

Product Engineering and Redesign: The factors that may necessitate re-engineering or
redesign of U.S. products may include differences in electrical and measurement systems.

Branding, Labelling and Packaging: Cultural considerations and customs may influence
branding, labelling and package considerations.

· Are certain colours used on labels and packages attractive or offensive?

· Do labels have to be in the local language?

· Must each item be labelled individually?

· Must each item be labelled individually?

· Are name brands important?

Installation: Another important element of product preparation is to ensure that the product can
be easily installed in the foreign location. Importers and exporters need to know they may also
consider providing training or providing manuals that have been translated into the local
language along with the product.

Warranties: In order to compete with competitors in the market, firms may have to include
warranties on their products.

Servicing: The service that U.S. companies provide for their products is of concern to foreign
consumers. Foreign consumers want to know whether they can access spare parts, technicians
who can service the product, and distributors of the products in their countries.

· Failure to obtain legal advice

While it is virtually impossible for any firm, no matter how big or small, to know all of the laws
that pertain to exporting from the U.S., as well as the relevant laws of other countries, there are
measures that can be taken by firms in the planning process to minimize the probability that they
will make unnecessary errors that have grave legal consequences

· Failure to understand export licensing requirements

Businesses that are new to the export arena may confuse the local and state rules regarding
business taxes, zoning and other issues, i.e., legal registrations, with the federal requirements
governing export licenses. In order to export an item that may be on the restricted list, an export
license is required. This allows the federal government to control the export of the goods. The
license is not required for every item exported.

The U.S. Department of Commerce Bureau of Export Administration (BXA) is the primary
licensing agency for dual-use exports (commercial items that could have military applications).
The first step in determining your license requirements is to classify your product using the
Commerce Control List (CCL). Once the product’s classification is determined, the following
five questions will determine your obligations under the EAR:

· What is the item you intend to export or re-export?

· Where is it going?

· Who will receive it?

· What will they do with it?

· What is the recipient’s other activities?

Q.4 Explain the product life cycle theory

Product Life Cycle Theory

The product life cycle (PLC) has represented a central element of marketing theory for four
decades. Following its development in the 1950s, and its subsequent popularization in the 1960s,
it has remained a stable feature of marketing teaching; despite evidence of its limited
applicability and the growing awareness, amongst leading academics at least, of its flawed nature

Life cycle theory has been used since the 1970s to describe the behaviour of a product or service
from design to obsolescence.

The typical pattern of a product is represented by a curve divided into four distinct phases:
introduction, growth, maturity, and decline. Recent research in the area has focused on its use in
decision making in areas ranging from those as broad as overall strategy to those as narrow as
equipment replacement.
But does the product life cycle, or PLC, really tell the entire story? Consider the Ford Mustang.
Since its 1964 introduction, the automobile has undergone several changes. Performance was
increased with the addition of the 428 CobraJet in 1968 and Mach I styling in 1969. Another
substantial change took place in 1971 with the introduction of the high-performance Boss 351.
Then a true muscle car, the Mustang was detuned in 1974, when oil prices forced a more fuel-
efficient redesign, called Mustang II. The fourth generation Mustang, introduced as the 1994
model, has been further refined and is more aerodynamic than its immediate predecessor. Yet it
still shares roots with earlier models. A 302 V-8 is still offered, the wheelbase is similar, and if
one looks closely enough, one can see its genesis in the 1964 model. The pattern evidenced by
the life of the Mustang, then, is several curves of introduction, growth, maturity, and decline.

Another intriguing example is the C-130 Hercules aircraft manufactured by Lockheed. The
company recently announced the sale of 25 "J" models to the Royal Air Force, which is the fifth
version of the Hercules originally produced in the 1950s. Although the aircraft resembles its
older relatives, the new model features a totally different electronics package and more powerful
engines. Here again, the Hercules PLC shows a curve with five local maximum points (swells of
activity, in effect), rather than the traditional, single maximum point, PLC curve.

The examples above suggest a PLC model represented by waves of product introductions,
growth, maturity, and decline. Design engineering, process engineering, product marketing,
production, and end-of-life decisions are key elements within the system. Each has its own cycle
consisting of varying levels of activity. The waves are triggered by critical decision points during
the life of a product, when production, operations, and marketing managers must optimize their
collective efforts.

Q.5 Discuss the implications of Heckscher-Ohlin theory model

Heckscher-Ohlin Trade Model

The Heckscher-Ohlin (HO hereafter) model was first conceived by two Swedish economists, Eli
Heckscher (1919) and Bertil Ohlin. Rudimentary concepts were further developed and added
later by Paul Samuelson and Ronald Jones among others. There are four major components of
the HO model:

1. Factor Price Equalization Theorem,

2. Stolper-Samuelson Theorem,

3. Rybczynski Theorem, and

4. Heckscher-Ohlin Trade Theorem.

Due to the difficulty of predicting the goods trade pattern in a world of many goods, instead of
the Heckscher-Ohlin Theorem, the Heckscher-Ohlin-Vanek Theorem that predicts the factor
content of trade received attention in recent years.

4.4.1 Eli Heckscher (1879 – 1952)

Heckscher was a Swedish economist. He is probably best known for his book "Mercantilist."
Although his major interest was in studying economic history, he also developed the essentials of
the factor endowment theory of international trade in a short article in Swedish in 1919. It was
translated into English thirty years later.

4.4.2 Bertil Ohlin (1899-1979)

Heckscher’s student, Bertil Ohlin developed and elaborated the factor endowment theory. He
was not only a professor of economics at Stockholm, but also a major political figure in Sweden.
He served in Riksdag (Swedish Parliament), was the head of liberal party for almost a 1/4 of a
century. He was Minister of Trade during World War II. In 1979 Ohlin was awarded a Nobel
prize jointly with James Meade for his work in international trade theory.

HO Model = 2 × 2 × 2 model (2 countries, 2 commodities, 2 factors)

For example, there are two countries (America and Britain); each country is endowed with 2
homogeneous factors (labour and capital) and produces 2 commodities.

This is the smallest case of "even" model, i.e., the number of commodities is equal to that of
factors. Extending the model to a more general case is not easy. In fact, the results obtained from
a more general model do not have the clear, common sense interpretations which the simple HO
model enjoys.

4.4.3 Factor Price Equation Theorem

Among the four main results of the HO theory, FPE is the most fragile theorem. If any of the
eight assumptions are violated, it will not hold. However, this is one of the most powerful
findings, if not the most important one, in trade theory, as it shows how trade affects the income
distribution of a trading country.

Of course, the assumptions are somewhat unrealistic in the sense that they are not likely to be
observed in the real world. However, even if some of the assumptions are violated, international
trade has a tendency to equalize factor prices; it will remove the wage gaps between countries,
despite the constraint that trading countries impose on the movement of factors, in particular, on
the movement of workers.

Assumptions

1. No barriers to trade
World trade is assumed to be free from any impediments, such as tariffs, quotas, voluntary
export restraints, and exchange control.
2. No transportation cost
Procession of Horsemen and
Chariots, Eastern Han, 25 – 220
AD.
After the industrial revolution in the
mid 1800s, major cities were connected
by railroads, reducing the
transportation costs further. Lawrence
of Arabia helped the Arabs to recapture
Arabia from the Turks. Arabs
eventually ousted Turks from the
region now known as Saudi Arabia. As
a result, Israel gained its independence
in 1948.
Romans built good roads such as Via
Appia and Via Ignatia, connecting
various parts of the Empire, reducing
the transportation costs. Good roads
made it possible for the Romans and
the Chinese to utilize horse drawn
chariots for fast communication and
transportation. There were bandits in
various regions and pirates in the
ocean, but the Romans made it
sufficiently safe for ordinary people to
travel.
 The Prodigal Son by Pierre puvis de
Chavannes (Washington National
Luke 15:13 "Not long after that, Gallery). This parable suggests that
the younger son got together all he people were able to travel easily to
had, set off for a distant country foreign countries during the time of
and there squandered his wealth in Jesus. Travel was relatively safe and
wild living. 14 After he had spent affordable by the emerging middle
everything, there was a severe class.
famine in that whole country, and
he began to be in need. So he went
and hired himself out to a citizen of
that country, who sent him to his
fields to feed pigs.

Transportation costs are assumed to be zero.

In reality, transportation costs are a significant portion of the marketing costs of most traded
goods, especially in agricultural products.

Remark: This is unrealistic. However, it is not a bad assumption, because transportation costs
inhibit and reduce trade volume; it does not reverse the trade pattern between the countries.

3. Perfect Competition (PC) + Full Employment (FE)

PC prevails in both product and factor markets. This assumption rules out monopolistic and
oligopolistic market structures. It also rules out price and wage rigidities. In a perfectly
competitive market all buyers and sellers are price takers, i.e., each one is too small to exert
market power and influence market prices. All factors are fully employed.

4. Factors are mobile in each country but are immobile across national borders.

Like Ricardo, HO model draws a sharp distinction between domestic and external factor
mobility. The maximum degree of factor mobility is permitted between industries within the
same country (internal factor mobility). But neither capital nor labour can cross national borders
(international factor immobility).

IFM insures that workers move from a low wage region to a high wage region, and capital moves
from a low interest country to a high interest region. The net effect is that all factor prices are the
same within a country.

IFI implies that Mexican workers are not allowed to work or migrate to the US.
5. No specialization

After the introduction of free trade, neither country specializes in one commodity, as in
Ricardian model. Each country produces both goods.

6. Production functions exhibit constant returns to scale (CRS) and differ among
industries:

Such a production function is sometimes said to be homogeneous of degree 1 – HD(1) for short
here.

CRS means that a proportionate increase in all inputs increases the output by the same
percentage.

Specifically, CRS means:

If y = F (L, K), then y’ = F (2L, 2K) = 2y.

7. Identical technology between trading countries:

Production functions are the same in America and Britain. The HO model is a long run model.
Ohlin argued that "the physical conditions of production are everywhere the same." Some
countries may be slow to adopt new technology. With the development of modern
telecommunications, information travels fast. This is a result of declining transportation and
communication costs.

The first page of Analects of Confucius

contains two verses in bold: The Master
said, "Is it not a pleasure to learn
something and practice it often?
"Is it not a joy to have friends visiting
you from far away quarters? (Characters
in regular font are the commentaries like
those of Bible interpreters.)

This book written by Confucius (551 –

473 BC) before Plato and Socrates
includes Zhu Xi’s commentaries. This
edition was printed in Japan before Meiji
Restoration. Trade spreads technologies.

Paper was invented by Cai Lun in AD

105. Printing with carved wood blocks
appeared during the Tang dynasty.
Movable type was invented during Song
dynasty (c. 1050 AD) long before the
 Gutenberg printing press.

8. No factor intensity reversal:

Remark: The implication of (1) and (2) is that commodity trade equalizes commodity prices
between countries. That is, Americans and Britons pay the same prices for same commodities.

Will commodity price equalization result in factor price equalization?

An Italian inscription which explains that the

body of an ancient ruler, Caesar, was
deposited here. Julius Caesar laid the
cornerstone of the Roman Empire (27 BC –
476 AD).

By conquering neighbouring countries,

Julius Caesar’s tomb in
Roman government also provided police
Palatino Hill, Rome (May
function and ensured safety of travellers. For
2003)
example, Praetorian Guard and Roman
legions stationed in various outposts
provided peace and maintained law and order
throughout the Roman Empire. As a result,
international trade flourished on an
unprecedented scale. Licinius Crassus
crushed the Spartacus rebellion (71 BC).
Unit Value Isoquants

A unit value isoquant is a locus of input combinations that yield $1 worth of output.

1) Among many isoquants choose the one for which p*2y2 = 1, or y2 = 1/p*2.

Figure 4.1, Unit value isoquant

Figure 4.1

2) Different production functions yield different isoquants:

Two different UVIs intersect each other.

Figure 4.2

In Figure 2, industry 2 is more capital intensive than industry 1.

3) Choose y2, L2, and K2 to

maximize Π = p*2y2 – wL2 – rK2

Subject to y2 = F2 (L2,K2).

Once the desired output is chosen, the cost must be minimized. The equilibrium condition is:

MRTS = w/r

Figure 4.3, Implication of cost minimization

Figure 4.3

4) "No specialization" implies that a common isocost curve must be tangent to both unit value
isoquants. Suppose not.

Arbitrary factor prices (w, r) results in specialization in one commodity.

Figure 4.4

An arbitrary pair of factor prices (w ,r) cannot prevail, because it causes the economy to
specialize in one good. For instance, given the factor prices represented by the slopes of the two
isocost curves, industry 2 survives at point A (p2y2 = c2) the tangency points (both A and B) yield
exactly $1 revenue. But the production costs at points 1 and 2 will differ. For example, C1 > C2 =
1. Thus, firms will produce only commodity 2, which costs less but yields the same revenue.
That is, the country specializes in good 2 in the above example.

Thus, for a given pair of output prices (p1, p2), there exists a unique pair of factor prices (w,r).
This implies that a pair of output prices completely determines a pair of factor prices. Within a
country, (p*1,p*2) <=> (w ,r).

Figure 4.5: Common Isocost Curve

4.4.4 Factor Price Equalization Theorem

Given assumptions 1 – 8, factor prices will be equalized between countries. That is,

w = w*, r = r*.

Woman ironing, Edgar Degas. How will her wage be affected by free trade?

Proof

1. PC in factor markets + No specialization imply

w = p1MPL1 = P2MPL2

r = p1MPK1 = P2MPK2

w/r = MPL1/MPK1 = MRTS1 = the slope of UVI: y1 = 1/p1.

= MPL2/MPK2 = MRTS2 = the slope of UVI: y2 = 1/p2.

Thus, in the Home country, a common isocost curve is tangent to both UVIs.

2. The same is true in the foreign country. w* = p*1MP*L1 = p*2MP*L2

r* = p*1MP*K1 = p*2MP*K2

3. No Barriers to Trade + No Transportation Costs imply

p*1 = p1 and p*2 = p2. (Free trade implies output price equalization)

Thus, w* = p*1MP*L1 = p1MP*L1. But will marginal products of labor in any industry be the same
in the two countries?

4. Identical Technologies

- IT: both countries have the same isoquant maps. This and (3) imply that HC and FC have the
same set of unit value isoquants.

- No FIR implies that expansion paths are unique in each country, and the two countries have the
same expansion paths, as shown in Figure 6.

(k1 = k*1, k2 = k*2).

Figure 4.6. Effects of CRS on marginal products.

Figure 4.6

- HD(1) or CRS: Expansion paths are rays from the origin, along which MPs remain constant.
Each country chooses an input allocation along each expansion path, depending on its resource
endowment. However, regardless of their locations, A = (L1,K1) and B = (L*1,K*1), marginal
product of each input does not depend on the output level; it depends only on the capital-labor
ratios. In Figure 5a, CRS implies that marginal products remain constant along each expansion
path, regardless of the output levels. Thus,

MP*Li = MPLi, MP*Ki = MPKi.

5. w* = p*iMP*Li = piMPLi = w, (wage equalization)

r* = p*i MP*Ki = piMPKi = r. (interest rate equalization)

Q.6 Do you think WTO is helpful for promoting international business? Give reasons for your answer.

Set 2

Q.1 What is WTO? What is GATT? Explain both

Introduction

The World Trade Organization came into being in 1995. One of the youngest of the international
organizations, the WTO is the successor to the General Agreement on Tariffs and Trade (GATT)
established in the wake of the Second World War. So while the WTO is still young, the
multilateral trading system that was originally set up under GATT is well over 50 years old.

Objective

After studying this unit, the students would be able to:

- Assess the evaluation of The World Trade Organization (WTO), a multilateral organization
dealing with the global rules of trade among nations, was created on January 1, 1995.

- Discuss the salient features of this WTO and also highlight how the trade terms function in
accordance with these trade treaties.

The past 50 years have seen an exceptional growth in world trade. Merchandise exports grew on
average by 6% annually. Total trade in 2000 was 22-times the level of 1950. GATT and the
WTO have helped to create a strong and prosperous trading system contributing to
unprecedented growth.

The system was developed through a series of trade negotiations, or rounds, held under GATT.
The first rounds dealt mainly with tariff reductions but later negotiations included other areas
such as anti-dumping and non-tariff measures. The last round – the 1986-94 Uruguay Round –
led to the creation of WTO.

The negotiations did not end there. Some continued after the end of the Uruguay Round. In
February 1997, agreement was reached on telecommunications services, with 69 governments
agreeing to wide-ranging liberalization measures that went beyond those agreed in the Uruguay
Round.
In the same year 40 governments successfully concluded negotiations for tariff-free trade in
information technology products, and 70 members concluded a financial services deal covering
more than 95% of trade in banking, insurance, securities and financial information.

In 2000, new talks started on agriculture and services. These have now been incorporated into a
broader agenda launched at the fourth WTO Ministerial Conference in Doha, Qatar, in
November 2001.

The work programme, the Doha Development Agenda (DDA), adds negotiations and other work
on non – agricultural tariffs, trade and environment, WTO rules such as anti-dumping and
subsidies, investment, competition policy, trade facilitation, transparency in government
procurement, intellectual property, and a range of issues raised by developing countries as
difficulties they face in implementing the present WTO agreements.

5.2 History of World Trade Organization

World Trade Organization Came into existence in 1995 after the desolation of General
Agreement on Tariff and Trade (GATT) Lets first understand the historical perspective of GATT
to scale the ladder towards the present WTO

5.2.1 A Brief History of GATT

The WTO’s Predecessor, The GATT, Was Established on a Provisional Basis after the Second
World War in the wake of other new multilateral institutions dedicated to international economic
cooperation – notably the "Britton Woods" institutions now known as the World Bank and the
International Monetary Fund.

The original 23 GATT countries were among over 50 which agreed a draft Charter for an
International Trade Organization (ITO) – a new specialized agency of the United Nations. The
Charter was intended to provide not only world trade disciplines but also contained rules relating
to employment, commodity agreements, restrictive business practices, international investment
and services.

In an effort to give an early boost to trade liberalization after the Second World War and to begin
to correct the large overhang of protectionist measures which remained in place from the early
1930s-tariff negotiations were opened among the 23 founding GATT "contracting parties" in
1946. This first round of negotiations resulted in 45,000 tariff concessions affecting $10 billion
or about one-fifth – of world trade. It was also agreed that the value of these concessions should
be protected by early and largely "provisional" acceptance of some of the trade rules in the draft
ITO Charter. The tariff concessions and rules together became known as the General Agreement
on Tariffs and Trade and entered into force in January 1948.

Although the ITO Charter was finally agreed at a UN Conference on Trade and Employment in
Havana in March 1948, ratification in national legislatures proved impossible in some cases.
When the United States’ government announced, in 1950, that it would not seek Congressional
ratification of the Havana Charter, the ITO was effectively dead. Despite its provisional nature,
the GATT remained the only multilateral instrument governing international trade from 1948
until the establishment of the WTO.

Although, in its 47 years, the basic legal text of the GATT remained much as it was in 1948,
there were additions in the form of "plural-lateral” voluntary membership agreements and
continual efforts to reduce tariffs. Much of this was achieved through a series of "trade rounds".

How is the WTO different from GATT?

The World Trade Organization is not a simple extension of GATT; on the contrary, it completely
replaces its predecessor and has a very different character. Among the principal differences are
the following:

– The GATT was a set of rules, a multilateral agreement, with no institutional foundation, only a
small associated secretariat which had its origins in the attempt to establish an International
Trade Organization in the 1940s. The WTO is a permanent institution with its own secretariat.

– The GATT was applied on a "provisional basis" even if, after more than forty years,
governments chose to treat it as a permanent commitment. The WTO commitments are full and
permanent.

– The GATT rules applied to trade in merchandise goods. In addition to goods, the WTO covers
trade in services and trade-related aspects of intellectual property.

– While GATT was a multilateral instrument, by the 1980s many new agreements had been
added of a plural-lateral, and therefore selective, nature. The agreements which constitute the
WTO are almost all multilateral and, thus, involve commitments for the entire membership.

– The WTO dispute settlement system is faster, more automatic, and thus much less susceptible
to blockages, than the old GATT system. The implementation of WTO dispute findings will also
be more easily assured.

The "GATT 1947" will continue to exist until the end of 1995, thereby allowing all GATT
member countries to accede to the WTO and permitting an overlap of activity in areas like
dispute settlement. Moreover, GATT lives on as "GATT 1994", the amended and up-dated
version of GATT 1947, which is an integral part of the WTO Agreement and which continues to
provide the key disciplines affecting international trade in goods.

Q.2 What is MNC? Explain the 3 stages of evolution.

Multinational Corporations

Economists are not in agreement as to how multinational or transnational corporations should be

defined. Multinational corporations have many dimensions and can be viewed from several
perspectives (ownership, management, strategy and structural, etc.) The following is an excerpt
from Franklin Root (International Trade and Investment, 1994)

Ownership criterion: some argue that ownership is a key criterion. A firm becomes
multinational only when the headquarter or parent company is effectively owned by nationals of
two or more countries. For example, Shell and Unilever, controlled by British and Dutch
interests, are good examples. However, by ownership test, very few multinationals are
multinational. The ownership of most MNCs is uni-national. (See videotape concerning the
Smith-Corona versus Brothers case) Depending on the case, each is considered an American
multinational company in one case, and each is considered a foreign multinational in another
case. Thus, ownership does not really matter.

Nationality mix of headquarter managers: An international company is multinational if the

managers of the parent company are nationals of several countries. Usually, managers of the
headquarters are nationals of the home country. This may be a transitional phenomenon. Very
few companies pass this test currently.

Business Strategy: global profit maximization

According to Howard Perlmutter (1969)*:

Multinational companies may pursue policies that are home

country – oriented or host country – oriented or world – oriented. Perlmutter uses such terms
as ethnocentric, polycentric and geocentric. However, "ethnocentric" is misleading because it
focuses on race or ethnicity, especially when the home country itself is populated by many
different races, whereas "polycentric" loses its meaning when the MNCs operate only in one or
two foreign countries.

According to Franklin Root (1994), an MNC is a parent company that

1. engages in foreign production through its affiliates located in several countries,

2. exercises direct control over the policies of its affiliates,

3. implements business strategies in production, marketing, finance and staffing that transcend
national boundaries.

In other words, MNCs exhibit no loyalty to the country in which they are incorporated.

*Howard V. Perlmutter, "The Tortuous Evolution of the Multinational Corporation," Columbia

Journal of World Business, 1969, pp. 9-18.

6.2.1 Three Stages of Evolution

1. Export stage
· initial inquiries Þ firms rely on export agents

· expansion of export sales

· further expansion Þ foreign sales branch or assembly operations (to save transport cost)

2. Foreign Production Stage

There is a limit to foreign sales (tariffs, NTBs)

DFI versus Licensing

Once the firm chooses foreign production as a method of delivering goods to foreign markets, it
must decide whether to establish a foreign production subsidiary or license the technology to a
foreign firm.

Licensing

Licensing is usually first experience (because it is easy)

e.g.: Kentucky Fried Chicken in the U.K.

· it does not require any capital expenditure

· it is not risky

· payment = a fixed % of sales

Problem: the mother firm cannot exercise any managerial control over the licensee (it is
independent)

The licensee may transfer industrial secrets to another independent firm, thereby creating a rival.

Direct Investment

It requires the decision of top management because it is a critical step.

· it is risky (lack of information) (US firms tend to establish subsidiaries in Canada first. Singer
Manufacturing Company established its foreign plants in Scotland and Australia in the 1850s)

· plants are established in several countries

· licensing is switched from independent producers to its subsidiaries.

· export continues
3. Multinational Stage

The company becomes a multinational enterprise when it begins to plan, organize and coordinate
production, marketing, R&D, financing, and staffing. For each of these operations, the firm must
find the best location.

Q.3 Mention the differences between currency markets and exchange rate markets
in the context of international business environment

Exchange Rate Markets and Currency Markets

The exchange rate regimes adopted by countries in today’s international monetary and financial
system, and the system itself, are profoundly different from those envisaged at the 1944 meeting
at Bretton Woods establishing the IMF and the World Bank. In the Bretton Woods system:

· exchange rates were fixed but adjustable. This system aimed both to avoid the undue volatility
thought to characterize floating exchange rates and to prevent competitive depreciations, while
permitting enough flexibility to adjust to fundamental disequilibrium under international
supervision;

· private capital flows were expected to play only a limited role in financing payments
imbalances, and widespread use of controls would prevent instability in such flows;

· temporary official financing of payments imbalances, mainly through the IMF, would smooth
the adjustment process and avoid unduly sharp correction of current account imbalances, with
their repercussions on trade flows, output, and employment.

In the current system, exchange rates among the major currencies (principally the U.S. dollar, the
euro, and Japanese yen) fluctuate in response to market forces, with short-run volatility and
occasional large medium-run swings (Figure 1). Some medium-sized industrial countries also
have market – determined floating rate regimes, while others have adopted harder pegs,
including some European countries outside the euro area. Developing and transition economies
have a wide variety of exchange rate arrangements, with a tendency for many but by no means
all countries to move toward increased exchange rate flexibility (Figure 2).

This variety of exchange rate regimes exists in an environment with the following
characteristics:

· partly for efficiency reasons, and also because of the limited effectiveness of capital controls,
industrial countries have generally abandoned such controls and emerging market economies
have gradually moved away from them. The growth of international capital flows and
globalization of financial markets has also been spurred by the revolution in telecommunications
and information technology, which has dramatically lowered transaction costs in financial
markets and further promoted the liberalization and deregulation of international financial
transactions;

· international private capital flows finance substantial current account imbalances, but the
changes in these flows appear also sometimes to be a cause of macroeconomic disturbances or an
important channel through which they are transmitted to the international system;

· developing and transition countries have been increasingly drawn into the integrating world
economy, in terms of both their trade in goods and services and of financial transactions.

Lessons from the recent crises in emerging markets are that for such countries with important
linkages to global capital markets, the requirements for sustaining pegged exchange rate regimes
have become more demanding as a result of the increased mobility of capital. Therefore, regimes
that allow substantial exchange rate flexibility are probably desirable unless the exchange rate is
firmly fixed through a currency board, unification with another currency, or the adoption of
another currency as the domestic currency (dollarization).

Flexible exchange rates among the major industrial country currencies seem likely to remain a
key feature of the system. The launch of the euro in January 1999 marked a new phase in the
evolution of the system, but the European Central Bank has a clear mandate to focus monetary
policy on the domestic objective of price stability rather than on the exchange rate. Many
medium-sized industrial countries, and developing and transition economies, in an environment
of increasing capital market integration, may also continue to maintain market-determined
floating rates, although more countries could may adopt harder pegs over the longer term. Thus,
prospects are that:

· exchange rates among the euro, the yen, and the dollar are likely to continue to exhibit
volatility, and schemes to reduce volatility are neither likely to be adopted, nor to be desirable as
they prevent monetary policy from being devoted consistently to domestic stabilization
objectives;

· several of the transition countries of central and eastern Europe, especially those preparing for
membership in the European Union, are likely to seek to establish over time the policy
disciplines and institutional structures required to make possible the eventual adoption of the
euro.

The approach taken by the IMF continues to be to advise member countries on the implications
of adopting different exchange rate regimes, to consider the choice of regime to be a matter for
each country to decide and to provide policy advice that is consistent with the maintenance of the
chosen regime (Box 3).
Q.4 a) Explain the role of privatization in international business. [05 marks]

b) Mention the relevance of these international commercial terms: FCA, EXW, DES, CIF and DDP

Q.5 Give short notes on Letter of credit and Bill of Lading

.4.1 Letter of Credit

A letter of credit is a document issued mostly by a financial institution which usually provides an
irrevocable payment undertaking (it can also be revocable, confirmed, unconfirmed, transferable
or others e.g. back to back: revolving but is most commonly irrevocable/confirmed) to a
beneficiary against complying documents as stated in the credit. Letter of Credit is abbreviated
as an LC or L/C, and often is referred to as a documentary credit, abbreviated as DC or D/C,
documentary letter of credit, or simply as credit (as in the UCP 500 and UCP 600). Once the
beneficiary or a presenting bank acting on its behalf, makes a presentation to the issuing bank or
confirming bank, if any, within the expiry date of the LC, comprising documents complying with
the terms and conditions of the LC, the applicable UCP and international standard banking
practice, the issuing bank or confirming bank, if any, is obliged to honour irrespective of any
instructions from the applicant to the contrary. In other words, the obligation to honour (usually
payment) is shifted from the applicant to the issuing bank or confirming bank, if any. Non-banks
can also issue letters of credit however parties must balance potential risks.

Letters of credit accomplish their purpose by substituting the credit of the bank for that of the
customer, for the purpose of facilitating trade. There are basically two types: commercial and
standby. The commercial letter of credit is the primary payment mechanism for a transaction,
whereas the standby letter of credit is a secondary payment mechanism.

Commercial Letter of Credit

Commercial letters of credit have been used for centuries to facilitate payment in international
trade. Their use will continue to increase as the global economy evolves.

Letters of credit used in international transactions are governed by the International Chamber of
Commerce Uniform Customs and Practice for Documentary Credits. The general provisions and
definitions of the International Chamber of Commerce are binding on all parties. Domestic
collections in the United States are governed by the Uniform Commercial Code.

A commercial letter of credit is a contractual agreement between issuing banks, on behalf of one
of its customers, authorizing another bank, known as the advising or confirming bank, to make
payment to the beneficiary. The issuing bank, on the request of its customer, opens the letter of
credit. The issuing bank makes a commitment to honour drawings made under the credit. The
beneficiary is normally the provider of goods and/or services. Essentially, the issuing bank
replaces the bank’s customer as the payee.

Elements of a Letter of Credit

· A payment undertaking given by a bank (issuing bank)

· On behalf of a buyer (applicant)

· To pay a seller (beneficiary) for a given amount of money

· On presentation of specified documents representing the supply of goods

· Within specified time limits

· Documents must conform to terms and conditions set out in the letter of credit

· Documents to be presented at a specified place

Beneficiary
The beneficiary is entitled to payment as long as he can provide the documentary evidence
required by the letter of credit. The letter of credit is a distinct and separate transaction from the
contract on which it is based. All parties deal in documents and not in goods. The issuing bank is
not liable for performance of the underlying contract between the customers and beneficiary. The
issuing bank’s obligation to the buyer is to examine all documents to insure that they meet all the
terms and conditions of the credit. Upon requesting demand for payment the beneficiary warrants
that all conditions of the agreement have been complied with. If the beneficiary (seller) conforms
to the letter of credit, the seller must be paid by the bank.

Issuing Bank

The issuing bank’s liability to pay and to be reimbursed from its customer becomes absolute
upon the completion of the terms and conditions of the letter of credit. Under the provisions of
the Uniform Customs and Practice for Documentary Credits, the bank is given a reasonable
amount of time after receipt of the documents to honour the draft.

The issuing banks’ role is to provide a guarantee to the seller that if compliant documents are
presented, the bank will pay the seller the amount due and to examine the documents, and only
pay if these documents comply with the terms and conditions set out in the letter of credit.

Typically the documents requested will include a commercial invoice, a transport document such
as a bill of lading or airway bill and an insurance document; but there are many others. Letters of
credit deal in documents, not goods.

Advising Bank

An advising bank, usually a foreign correspondent bank of the issuing bank will advise the
beneficiary. Generally, the beneficiary would want to use a local bank to insure that the letter of
credit is valid. In addition, the advising bank would be responsible for sending the documents to
the issuing bank. The advising bank has no other obligation under the letter of credit. If the
issuing bank does not pay the beneficiary, the advising bank is not obligated to pay.

Confirming Bank

The correspondent bank may confirm the letter of credit for the beneficiary. At the request of the
issuing bank, the correspondent obligates itself to insure payment under the letter of credit. The
confirming bank would not confirm the credit until it evaluated the country and bank where the
letter of credit originates. The confirming bank is usually the advising bank.

Letter of Credit Characteristics

Negotiability
Letters of credit are usually negotiable. The issuing bank is obligated to pay not only the
beneficiary, but also any bank nominated by the beneficiary. Negotiable instruments are passed
freely from one party to another almost in the same way as money. To be negotiable, the letter of
credit must include an unconditional promise to pay, on demand or at a definite time. The
nominated bank becomes a holder in due course. As a holder in due course, the holder takes the
letter of credit for value, in good faith, without notice of any claims against it. A holder in due
course is treated favourably under the UCC.
The transaction is considered a straight negotiation if the issuing bank’s payment obligation
extends only to the beneficiary of the credit. If a letter of credit is a straight negotiation it is
referenced on its face by "we engage with you" or "available with ourselves". Under these
conditions the promise does not pass to a purchaser of the draft as a holder in due course.

Revocability
Letters of credit may be either revocable or irrevocable. A revocable letter of credit may be
revoked or modified for any reason, at any time by the issuing bank without notification. A
revocable letter of credit cannot be confirmed. If a correspondent bank is engaged in a
transaction that involves a revocable letter of credit, it serves as the advising bank.

Once the documents have been presented and meet the terms and conditions in the letter of
credit, and the draft is honoured, the letter of credit cannot be revoked. The revocable letter of
credit is not a commonly used instrument. It is generally used to provide guidelines for shipment.
If a letter of credit is revocable it would be referenced on its face.

The irrevocable letter of credit may not be revoked or amended without the agreement of the
issuing bank, the confirming bank, and the beneficiary. An irrevocable letter of credit from the
issuing bank insures the beneficiary that if the required documents are presented and the terms
and conditions are complied with, payment will be made. If a letter of credit is irrevocable it is
referenced on its face.

Transfer and Assignment

The beneficiary has the right to transfer or assign the right to draw, under a credit only when the
credit states that it is transferable or assignable. Credits governed by the Uniform Commercial
Code (Domestic) maybe transferred an unlimited number of times. Under the Uniform Customs
Practice for Documentary Credits (International) the credit may be transferred only once.
However, even if the credit specifies that it is non-transferable or non-assignable, the beneficiary
may transfer their rights prior to performance of conditions of the credit.

Sight and Time Drafts

All letters of credit require the beneficiary to present a draft and specified documents in order to
receive payment. A draft is a written order by which the party creating it, orders another party to
pay money to a third party. A draft is also called a bill of exchange.

There are two types of drafts: sight and time. A sight draft is payable as soon as it is presented
for payment. The bank is allowed a reasonable time to review the documents before making
payment.

A time draft is not payable until the lapse of a particular time period stated on the draft. The bank
is required to accept the draft as soon as the documents comply with credit terms. The issuing
bank has a reasonable time to examine those documents. The issuing bank is obligated to accept
drafts and pay them at maturity.
Standby Letter of Credit

The standby letter of credit serves a different function than the commercial letter of credit. The
commercial letter of credit is the primary payment mechanism for a transaction. The standby
letter of credit serves as a secondary payment mechanism. A bank will issue a standby letter of
credit on behalf of a customer to provide assurances of his ability to perform under the terms of a
contract between the beneficiaries. The parties involved with the transaction do not expect that
the letter of credit will ever be drawn upon.

The standby letter of credit assures the beneficiary of the performance of the customer’s
obligation. The beneficiary is able to draw under the credit by presenting a draft, copies of
invoices, with evidence that the customer has not performed its obligation. The bank is obligated
to make payment if the documents presented comply with the terms of the letter of credit.

Standby letters of credit are issued by banks to stand behind monetary obligations, to insure the
refund of advance payment, to support performance and bid obligations, and to insure the
completion of a sales contract. The credit has an expiration date.

The standby letter of credit is often used to guarantee performance or to strengthen the credit
worthiness of a customer. In the above example, the letter of credit is issued by the bank and held
by the supplier. The customer is provided open account terms. If payments are made in
accordance with the suppliers’ terms, the letter of credit would not be drawn on. The seller
pursues the customer for payment directly. If the customer is unable to pay, the seller presents a
draft and copies of invoices to the bank for payment.

The domestic standby letter of credit is governed by the Uniform Commercial Code. Under these
provisions, the bank is given until the close of the third banking day after receipt of the
documents to honour the draft.

Bill of Lading

A Bill of Lading is a type of document that is used to acknowledge the receipt of a shipment of
goods and is an essential document in transporting goods overland to the exporter’s international
carrier. A through Bill of Lading involves the use of at least two different modes of transport
from road, rail, air and sea. The term derives from the noun "bill", a schedule of costs for
services supplied or to be supplied, and from the verb "to lade" which means to load a cargo onto
a ship or other form of transport.

In addition to acknowledging the receipt of goods, a Bill of Lading indicates the particular vessel
on which the goods have been placed, their intended destination, and the terms for transporting
the shipment to its final destination. Inland, ocean, through, and airway bill are the names given
to bills of lading.

Q.6 Discuss the entry methods in international business with relevant examples