European Business - Impact of International Trade to an Open Economy - Assignment Example

Introduction A record of transactions between two countries implying a difference in the total value between payments into and out of a country over a period of time is shown in balance of payments (BOP). BOP encompasses all transactions taking place between the residents of a country and rest of the world. BOP encompasses goods, services and income, transfers such as, gifts and pension as well as financial claims and liabilities. BOP is, thus, an important tool for formulating national and international economic policy (Economics.Help, 2014). Components of UK’s Balance of Payment The balance of payments consists of: Current Account comprising of trade in goods, services, investment incomes and current transfers Capital Account / Financial Account consisting of capital and financial flows, net investment and portfolio investment Errors and omissions The UK has faced a consistent deficit in the current account, which implies that amount of the goods and services imported is more than the export volume. Factors that can be held responsible for the current account deficit are noted below: Deficit in goods – Due to de-industrialisation, the UK has had a very large deficit of goods. Besides being a manufacturer of goods, the UK has increasingly become an importer of manufactured commodities such as, clothes, computers and cars. The UK is also an importer of food and oil. The surplus in service partly offsets the deficit in goods, but is not sufficient in order to overcome the trade deficit. Financial Flows – Over the years, the UK has increasingly attracted effective financial flows such as, portfolio investments, which in turn finance its current account deficit. Relatively low rate of saving – Individuals residing the UK has a relatively low rate of saving as compared to that of other countries. Then again, despite a rise in the saving rate, deterioration in the current account could not be prevented. High consumer spending – A rapid growth in consumer spending leads to an increase in imports, which in turn adversely affects the current account. During a boom in the economy, the saving rate appears to fall, unlike consumer spending, which increases and leads to a current account deficit (Economics.Help, 2014). Exchange Rate It is the value of one country’s currency in terms of another, indicating the rate at which a currency can be exchanged for another. The balance of payments model states that the foreign exchange rates are at an equilibrium level if the current account balance is stable. Reduction in foreign exchange reserves occurs due to a trade deficit, which ultimately depreciates the currency. In case of undervaluation of a currency, the country’s exports are rendered affordable and imports expensive. TERMS OF TRADE (TOT) TOT reflects the amount of exports needed to be sold in order to purchase imports. There is an improvement in the terms of trade if the price of exports increases and vice-versa. A prolonged decline in the terms of trade reduces the standard of living. On the other hand, an improvement in the terms of trade indicates a rise in export prices compared to import prices. Hence, such variation will lead to a rise in the quantity of imports and fall in that of exports. A fall in exchange rate also entails deterioration in the terms of trade, given that price of the exports declines. Impact of International Trade to an Open Economy International trade forms a major portion of a country’s GDP. Industrialisation, improvement in technology and globalisation has a major impact on international trade. International trade mainly deals with the trade of goods and services as mobility of the factors of production, such as, capital and labour, are relatively lesser. In this context, there are two concepts that come into play. These are explained below. Absolute Advantage – When a country produces any good or services at a lower per unit cost compared to another country, it is termed as absolute advantage. Comparative Advantage – When a country produces any good or services at a lower opportunity cost compared to that of another country, it is said to have a comparative advantage in production of the same. International trade has been explained by the help of three models. Adam Smith’s Model – Adam Smith had explained absolute advantage in the context of international trade by using labour as the only input. The researcher had explained the presence of trade between two countries on the basis of absolute advantage. Ricardian Model – The Ricardian model is relatively more focused on comparative advantage, which is caused by the technological differences or that in natural resources. The Ricardian model does not deal with factor endowments like, labour and capital, within a country. Hecksher-ohlin Model – Also known as the H-O model, this model explains the trade conducted between two countries, where a country will export only those goods that require the use of factors found in abundance in production and import goods that demand less abundant factors in the country. Effect of EU membership on the UK’s trade relations The UK economy is affected by the EU membership in several ways; for example, the programme of economic integration through which the EU’s “Four Freedoms” are guaranteed implying the free movement of goods, capital, services and people. In addition, the EU has an exclusive ability to negotiate trade and investment agreements with non-member countries. As a result, EU membership greatly affects the UK’s trade relations with non-member countries. There are other fiscal consequences that arise out of the UK’s contributions to the EU budget. The EU membership also influences investment decisions of the foreign investors (European Commission, 2001). All member states of the EU are bound by a common tariff rule, according to which no tariff will be applied on the goods traded between the member states and a common tariff is levied on those imported from outside the EU. However, the member states are not allowed to operate independently and formulate trade policies by pursuing bilateral free trade agreements with non-member countries. Principle of free trade between the member countries, even on a cross-border basis, is stated in the EU treaties. The UK government has suggested further reduction of intra-EU barriers to trade, thereby causing a 7% rise in the GDP (European Commission, 2001). In case the UK decides to leave the EU, the nation has to face certain implications. Then again, the terms of World Trade Organisation (WTO) membership limit the range of consequences to an extent. Tariff Barriers By dint of the principle of non-discrimination, WTO requires all its members to treat each other equally. The regional free trade areas and customs union, similar to the EU, are an exception to this principle and apply special tariff rates to their member nations, thereby preventing the punitive practices of discriminatory tariff rates being applied to the member countries. Consequently, it is observed that the EU’s Most Favoured Nation (MFN) tariff has declined over time, implying that the membership advantage has also lowered (Thompson and Harari, 2013). Task 2 (LO 2) Economic Rationale of EU with respect to Exchange Rate Stability Among the member nations of the EU, exchange rate stability is promoted in order to reduce the incidence of foreign exchange risks as well as to smoothen the process of trading between them. Hence, introduction of any single currency encourages trade among the member states by way of eliminating the need to convert the nation’s home currency to that of its trading partner. Such an action stabilizes the exchange rate between member nations and in turn eases out trade between them (Lamine, 2006). The Single Currency The member states of the EU withinin the Euro zone follow a single currency, which facilitates trading as both the buyers and sellers can avoid the trouble of converting their currency as well as compromising on the price. With a single determining parameter, the process is simplified. Euro is the currency used by the Institutions of European Union and is regarded as official currency of the Euro-zone. Euro is deemed as the second largest reserve currency as well as the second largest most traded currency. It is being speculated that the growing role of euro as a regional anchor currency may soon lead to an enhancement in the European Monetary Union (Grauwe, 2005). Free Trade vs. Protectionism Protectionism is the policy of restricting trade between two countries mainly in order to reduce flow of imports into a country. The restricting measures imposed are generally tariffs on imported goods, quotas and a variety of other government regulations, also known as non-tariff barriers (Duina, 2006). Fig 1: Tariffs and Quotas (Source: Pindyck and Rubinfeld, 1995) The reasons behind protectionism lie in the urge to protect domestic small scale industries, protect domestic employment, strategic reasons, political reasons and prevent dumping. Free Trade on the other hand, is the policy of opening markets and not that of restricting imports and exports. This is mainly exemplified by the EU and the North American Free Trade Agreement (NAFTA). The major features of free trade are the trade of goods and services without taxes or other trade barriers, absence of policies that distort trade and free entry and exit in the markets. Factor Mobility The four factors of production are land, labour, financial capital, capital equipment and entrepreneurship. The easy flow of these factors between nations is needed and should be facilitated in order to continue trade smoothly. The economic costs of moving these factors should be less. The factor-price equalisation theorem states that when prices of the factor goods are equalized between two countries under free trade, the factor prices will also be equalised. Thus, free trade will even out the interest earned on capital and wage on labour across nations (Suranovic, 2013). Task 3 (LO 3) The EU functions in a similar manner in which any government body or legal entity operates. Considering the fact there are a number of member nations all over Europe and in parts of Asia, it is necessary for the EU to have institutions for the purpose of assisting in a smooth operation. The laws and policies formulated by the EU must be effective and functional so as to achieve the mission related goals. The EU has some major institutions that are as follows: European Parliament – It plays the critical role of formulating and developing policies and regulations that directly affect growth and prosperity of the nation. The representatives are directly elected by the EU citizens. The current president of the European parliament is Martin Schulz of Germany (Baldwin and Wyplosz, 2006) European Council – This council comprises representatives or relevant ministers of the governments of the member countries. The Presidency of the council is shared on a rotating basis among the member states. If agreement is found, then the council along with the parliament checks, amends and adopts the EU legislations proposed by the Commission. European Commission – This is responsible for proposing new laws to the Parliament and the Council as well as implementing the same once they are passed. The Commission also implements the EU policies on a day-to-day basis and manages its programmes and actions all over the world (European Parliament, 2009). EU Directives There are certain end results that must be met by every member state and that is laid down by the EU directives. Though the national authorities are free to decide ways of achieving these end results, yet it is mandatory to do so. The directives may take into account one or more member states and in certain circumstances, all of them. However, the directives are quite flexible giving adequate time to the national authorities of the member states for manoeuvring the internal situations accordingly so as meet deadlines. The directives encompass various fields such as, anti-discriminatory measures, accounting, auditing and management controls, culture, environment and pollution control, wildlife and nature conservation, intellectual property, pharmaceuticals, privacy and data protection, technology and safety of medical devices, electronic communication, information technology, weights and measures, transport covering both rail and road transport, capital requirements for bank capital, taxation of savings income in the form of interest payments and Alternative Investment Fund Managers Directive (AIFM) for hedge funds (European Commission, 2001). The EU Funding Programme European Social Fund (ESF) The major objective of the European Social Fund (ESF) is to extend employment opportunities. There are certain disadvantaged groups and unemployed and inactive individuals who face barriers to work. ESF aims to improve the situation by providing employment opportunities. The second priority of ESF is to develop a skilled and adaptable workforce. There are five Co-Financing Institutions (CFOs) that have been approved in the East of England to oversee and manage the delivery of ESF activity therein. These are namely DWP (via Jobcentre Plus), LSC, EEDA, Central Bedfordshire Council (replacing Bedfordshire County Council) and Luton Borough Council. European Regional Development Fund (ERDF) - (East of England European Regional Development Fund Competitiveness Programme: Towards Low carbon Development) This fund is specifically for the East of England and is administered by the East of England Development Agency (EEDA). This will support low carbon development and economic growth until 2013. The ERDF focuses on few key priority areas. This is also known as “thematic concentration” The three priorities of this funding are promotion of knowledge transfer and innovation to improve productivity, overcoming barriers to trade, business creation and expansion in order to stimulate and support successful business ventures and ensuring sustainable development, production and consumption (Ford, 2009). The ERDF resources that are allocated depend on the category of the region. In more developed regions it is mandatory that atleast 80% of the funds must be primarily focused on achieving any two of the above-mentioned priorities. The same focus in case of transition regions is for 60% of the funds. It is however, only 50% for the less developed regions. Furthermore, some ERDF resources must be channelled specifically towards low-carbon economy projects. This is 20% for more developed regions, 15% for transition regions and 12% for less developed regions. ERDF action plan was designed to reduce economic, environmental and social problems with special focus on attaining sustainable urban development. With the help of “integrated action” managed by cities 5% of the ERDF resources are set aside (European Commission, 2014). Task 4 (LO 4) A trading bloc is an economic integration that prevents excess imports made by its member nations from the non-member ones, which increasingly shapes the pattern of world trade. The EU is the largest trading bloc and the second largest economy, following the USA. In the following section, profile of the EU as a trading bloc has been analysed. The main advantages of a trading bloc are free trade within the bloc among member nations, market access and trade creation, economies of scale, job creation resulting from increased trade between the member countries and protection of industries belonging to the bloc from outside cheap imports (Frankel, Stein and Wei, 1997). The disadvantages entailed by the EU as a bloc can be listed as loss of benefits of free trade with non-member countries, distortion of world trade, exploitation of comparative advantage and inefficient producers may be preferred inside the bloc over the efficient ones operating externally, thereby causing diversion of trade. Retaliation is felt from other regional trading blocs, which surfaces after the creation of a bloc. For example, the trade disputes between the EU and the NAFTA (Frankel, Stein and Wei, 1997). Significance of trade barriers to the EU operations Linguistic: The cost of translating the patent documents in different languages was becoming more and more expensive. Hence, in order to reduce the same, the European Commission proposed English, French and German as official languages of the “common patent system” of the EU. Even so, Italy and Spain opposed to the trilingual system and proposed that Italian and Spanish should also be included as the official languages. The trilingual system can pose a problem for the rest of the world as this would deter a lot of other countries with different languages from trading. There has been numerous occurrences where patents have not been filed due to the huge cost structure of having to translate it into one of the official languages. Cultural: The EU trade operations are often hampered by the cultural differences present between member countries, in addition to the language barriers. In Europe, difference in business cultures is one of the major barriers to trade (European Commission, 2001). For example China has some distinct cultural differences from the EU countries and the Chinese are very deep-rooted people who value their culture a lot. Thus if China chooses to trade with any country of the EU, the cultural barriers are major problems that might hinder trade. The EU Funding Streams Fig 2: EU funding streams (Source: Ford, 2009) Action Plan for a specific company to trade in the EU A specific company willing to trade in the EU can always take advantage of the opportunities provided therein. The company can establish headquarters at the UK and subsequently expand to include the other member nations so as to widen the platform. Also, considering that the EU is an economic free zone, the company can expand in size easily. There are no foreign exchange risks or inhibitions to trade and free movement of the goods and services among the member nations. Such lack of inhibitions would help to facilitate a smooth flow of goods and services from the headquarters to the business branches or subsidiaries, or through distribution channels spread across other nations. The company can develop its infrastructure as the EU provides a very holistic environment for trade. The company can also take advantage of the economies of scale available by way of adopting expansion. Moreover, the EU has considerable negotiating power, which is exercised over the member nations. These myriad opportunities provided by the EU act as a platform for the company to expand on its ventures. Economic enhancements in the form of removal of tariffs and quotas and burdensome taxation systems help to create a region, which enables traders from different member countries of the EU to collectively undertake business and prosper. Reference List 1. Baldwin and Wyplosz, 2006. Institutions: the “Big Five”. [pdf] Baldwin and Wyplosz. Available at: < http://willmann.com/~gerald/euroecon-07/slides02.pdf > [Accessed 12 July 2014] 2. Duina, F. G., 2006. The social construction of free trade: The European Union, NAFTA, and Mercosur. Princeton University Press. 3. Economics. Help, 2014. UK Balance of Payments. [Online] Available at: [Accessed 11 July 2014]. 4. European Commission, 2001. Barriers to trade in Business Services. [pdf] Centre for Strategy & Evaluation Services. Available at: [Accessed 12 July 2014]. 5. European Parliament, 2009. THREE: 3 main institutions of the EU. [online] Available at: [Accessed 12 July 2014]. 6. Ford, V., 2009, EU FUNDING STREAMS A BRIEF GUIDE. [pdf] Available at: [Accessed 12 July 2014]. 7. Frankel, J. A., Stein, E., and Wei, S. J., 1997. Regional trading blocs in the world economic system. Washington DC: Peterson Institute. 8. Grauwe, P.D. and Schanbl, G., 2005. Exchange Rate Stability, Inflation and Growth in (South) Eastern and Central Europe. [pdf] mnb. Available at: [Accessed on 12 July 2014]. 9. Lamine, B., 2006. Monetary and exchange-rate agreements between the European Community and Third Countries [pdf] European Communities. Available at: [Accessed 12 July 2014]. 10. Pindyck, Robert, S. and Rubinfeld, L.D., 1995. Microeconomics. 3rd edn. New Jersey: Prentice Hall. 11. Suranovic, S., 2013. Factor Price Equalisation. [online] Available at: [Accessed 12 July 2014]. 12. Thompson, G. and Harari, D., 2013. The Economic Impact of EU membership. [pdf] House of Commons. Available at: [Accessed 11 July 2014]. 13. European Commission, 2014. European regional development Fund. [online] Available at : < http://ec.europa.eu/regional_policy/thefunds/regional/index_en.cfm> [Accessed 15 July 2014] Read More