You are on page 1of 19

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

It is a well known fact that the consideration of gain alone is the basis of all international economic transactions. Gains from trade refer to the advantages arising from international trade. The different approaches to the concept of gains from trade are as under: (a) Adam Smith's Approach According to Adam Smith, gains from international trade are in the form of the increased value of product and improvement in the productive capacity of each trading country. International trade leads to export of the commodity which is less in demand in the home market and import of the commodity which has stronger demand. Specialisation and division of labour reduce the cost structure and enlarge the size of market for each trading country. Thus, international trade maximizes world production and welfare. (b) Ricardo - Malthus Approach According to Ricardo and Malthus, specialization helps to save resource or costs. In the opinion of Malthus, gain from trade consists of "the increased value which results from exchanging what is wanted less for what is wanted more". (c) J.S.Mill's Approach J.S.Mill stressed the concept of reciprocal demand that determines terms of trade which is a ratio of quantity imported to the quantity exported by a given country. The terms of trade decide how the gain from trade is distributed between the trading partners. (d) Taussig's Approach According to Tausigg, the gains from international trade can accrue to a trading country in the form of a rise in income. This contributes to a higher level of welfare. (e) Modem Approach In the opinion of the modem economists international trade brings two types of gains. They are gains from exchange and gains from specialization. When trade commences, consumers enjoy a higher level of satisfaction, partly because of improvement in terms of trade and partly due to greater specialization in the use of economic resources of the country. 2.2 Gains from International Trade We can examine the gains from international trade under two heads. They are, (a) Static gains (b) Dynamic gains
1 Gains from Trade

International Trade and Finance - I

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

(a)

(b)

Static gains Static gains arise out of optimum utilisation of a country's factor resources. The utilisation of resources to the optimum level contributes to increasing national output and social welfare. Static gains comprise of the following gains: (i) Specialisation and Division of Labour International trade leads to specialization and geographical division of labour. Each country specializes itself in the production of that commodity for the production of which it enjoys a comparative cost advantage. International trade brings about all the advantages of specialization and division of labour at the international level. (ii) Maximisation of Production As a result of specialization and division of labour each country seeks to produce to the maximum extent possible. Thus, trade among countries leads to the maximization of world's output. (iii) Maximisation of Welfare By maximizing production, international trade makes available a large quantity of goods for consumption, This will have a positive impact on the economic welfare of the people world over. (iv) Rise in National Income International trade leads to a rise in national income because of the increase in employment and production. There will be a rise in per-capita income also. (v) Use of Surplus Resources International Trade provides opportunities to a country to exploit its surplus resources. This is due to the widening of the market made possible by international trade. Dynamic Gains Dynamic Gains of international trade are those gains that contribute significantly to the promotion of economic growth of the trading countries concerned. The following are the dynamic gains of international trade: (i) Widening of the Market An important gain of international trade is that it enlarges the size of the market for the products of trading countries. This is of much importance to those countries which have surplus output to dispose off. Widening of the market contributes significantly to an increase in specialization encouraging innovations and inventions. As a result, there will be an increase in productivity' and profit, contributing in the process, to an increase in economic growth. (ii) Educative Benefit The educative gain of international trade lies in its transfer of skills from one country to another. These skills include technical know-how, managerial skills, enterprise, ideas etc. The less developed countries will be immensely benefited as the recipients of these skills. .
2 Gains from Trade

International Trade and Finance - I

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

(iii) Efficient Utilisation of Resources International trade, based on comparative cost advantage, brings about efficient utilisation of the resources of the trading countries concerned. Resources will be put to the optimum use. (iv) Capital Accumulation The need to buy foreiqn goods and thereby increase consumption and the standard of living motivates people to save more. This will Contribute to increasing capital accumulation. (v) Capital Movements A significant gain from international trade lies in that it leads to capital movements from one country to another. This is of much advantage to the less developed countries. (vi) Advantages to Less Developed Countries Trade brings enormous gains to the less developed countries. These countries can import capital, technical know-how, managerial skills etc. All this helps to accelerate the pace of economic growth of these countries. Thus, the gains from international trade are many and varied. Potential Gain and Actual Gain A distinction has been made between Potential Gain and Actual Gain accruing from international trade. Potential Gain Potential Gain from trade for the two trading countries A and B, depends on the basis of the difference in domestic cost ratios of producing two commodities, X and Y. This may be symbolically expressed as under:Gp = Cx Cx Cy A CyB Cx = Cost per unit for X commodity Cy = Cost per unit for Y commodity The subscript A and 'B' signify the two countries. On the other hand, the actual gain from trade Ga, is determined by the difference in the price of the two commodities X and Y in the two countries. Thus, Ga = Px Px Py A PyB
3 Gains from Trade

Where Gp = Potential Gain

International Trade and Finance - I

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

Under conditions of Perfect competition and free trade, the cost ratio equals the price ratio of two commodities in each country such that Cx Px = Cy Py Consequently, the actual gain becomes equal to potential gain Gp = Ga It may be noted that equalization of actual gain and potential gain takes place . When there is an absence of tariff and other trade restrictions. If there is imperfect competition and in the presence of trade barriers, differences arise in cost and price ratios in each trading country. As the price ratio is more than the cost ratio, the actual gain from trade exceeds the potential trade gain. 2.3 Measurement of Gains from Trade International trade brings gains to all the trading countries. According to the classical economists, the following three criteria could be adopted to measure the gains from international trade: (a) (b) (c) (a) Reduction in the cost of production Enhancement of the real income, and The nature of terms of trade.

Reduction in the Cost of Production With the development of international trade, a country tends to specialize in the production of those commodities in which it enjoys a high comparative advantage or the least 'disadvantage. Specialisation leads to the production of output at reduced costs. In addition, it helps to improve efficiency and productivity of the country's labour. Hence, the gain from trade can also be measured in terms of the degree of improvement in the country's productivity. The gain from trade is reflected in the increase in the general marginal product of country's export sector. Thus, an index of cost reduction or improvement in the marginal physical product oflabour can be used as a criterion for measuring the gain from international trade.

(b)

Enhancement of Real Income This criterion of measuring the gain from international trade follows from the first criterion. According to this criterion enhancement of real income - the real income or the net national product of the country increases on account of international trade. Symbolically, G = Ya - Yb Where G = gain from trade Ya = national income after trade Yb = national income before trade.

International Trade and Finance - I

Gains from Trade

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

(c)

The Nature of Terms of Trade This is the most important and popular criterion of measuring the gains from international trade. Terms of trade refers to the ratio of the export price to import price of a country. Symbolically, terms of trade is represented as, Px Pm Where Px = Prices of exports Pm = Prices of imports The terms of trade may be favourable or unfavourable for a country. Terms of trade Px Px >1 . It will be unfavourable or adverse when <1 . will be favourable if Pm Pm When there is favourable terms of trade, the country reaps larger share of gain from international trade. The country can obtain more quantity of imports for a given quantity of its exports. On the other hand, when there is unfavourable terms of trade, the country concerned will enjoy a smaller gain from international trade. It may be noted that the terms of trade depends, among other factors, upon what is called reciprocal demand. Reciprocal demand refers to relative elasticities of demand for each other's produce by the trading countries. A country which has a more intense demand for the goods of the other country will suffer from unfavourable terms of trade and hence it will be the loser and the opposite country will be the gainer. In the opinion of modem economists the question of discussing gains from trade is not worthwhile. According to Ohlin, trade leads to the equalization of factor prices in the trading countries. This will offset the gain from international specialization. Moreover, in the modem world characterized by dynamic changes, any analysis of the gains from international trade based on the assumption of constant conditions is a futile exercise. Factors Determining Gains from Trade The following factors determine the size of gain from international trade: Terms of Trade If the terms of trade is favourable, the gains from international trade will be large. On the contrary, if the terms of trade is unfavourable, the gains from trade will be smaller. Differences in Cost Ratio Differences in comparative cost ratios of producing two commodities in the two trading countries influence the gains from trade. Greater the difference in cost ratio, more is the gain from trade for a country relative to the other.
5 Gains from Trade

2.4 (i)

(ii)

International Trade and Finance - I

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

(iii)

Reciprocal Demand Reciprocal demand refers to the elasticity of demand for the product of one country by the other country. A country whose demand for the foreign products is more elastic but the demand for its products from the foreigners is less elastic, is likely to gain the most from international trade. (iv) Level of Income The level of income is another factor that determines gains from trade. Import of relatively cheaper commodities while domestic money incomes are high indicates the gain from trade. On the contrary, low domestic income due to low exports or high imports, while import prices are high will lead to smaller gain from trade. (v) Productive Efficiency If there is an improvement in the productive efficiency in the home country, costs and product prices fall. In this case the foreign country stands to gain. If there is an improvement in the productive efficiency, the home country stands to gain. (vi) Factor Endowments and Technological Conditions A country with plenty of capital and advanced technology will have a larger gain from trade. On the other hand, a technologically backward country with abundant supply of labour will have a smaller gain from international trade. (vii) Composition of Exports If the exports of a country comprise mainly of primary commodities, it will have a smaller gain from international trade. If a country's exports are diversified and consist mainly of manufactured goods, it will enjoy a larger gain from international trade. (viii) Size of the Country A small country with limited resources and specialization will have a smaller gain from international trade. But a large country is placed in a better position and enjoys a large gain from trade. Thus, gains from international trade depend upon a wide variety of factors. 2.5 Terms of Trade (ToT) The concept of ToT occupies a crucial place in international trade. Its significance lies in that it helps to determine how the gains from trade are allocated among the trading countries. Further, ToT has profound influence on the balance of payments position of the countries. Meaning In simple words, ToT refers to the rate at which a country exchanges its goods for the goods of another country. It depends mainly upon the prices of exports and imports. Thus, ToT expresses the relationship between the export prices and the import prices.
International Trade and Finance - I 6 Gains from Trade

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

A distinction is made between favourable ToT and unfavourable ToT. The ToT of a country is said to be favourable when the prices of its exports are more than the prices of its imports. On the contrary, the ToT of a country is said to be unfavourable or adverse when its export prices are less than its import prices. 2.6 Concepts of Terms of Trade Economists have offered various concepts of terms of trade. According to G.M.Meier, these concepts of terms of trade could be broadly classified into three categories: On the basis of ratio of international exchange between commodities On this basis, three concepts of terms of trade could be distinguished. They are, (a) Net Barter Terms of Trade (b) Gross Barter Terms of Trade, and (c) Income Terms of trade Net Barter Terms of Trade This concept introduced by F.W.Tausigg, was called Commodity Terms of Trade by Jacob Viner. Net Barter Terms of trade represents the ratio of export prices to import prices. Symbolically it is expressed as, Px Tc = Pm Where Tc = Commodity or net barter terms of trade Px = export price Pm = import price If we want to compare changes in net barter terms of trade between two periods, this concept is expressed as, Px 0 Px Tc = 1 x x100 Pm1 Pm0 Where Px1 = export price in the current year Pm1 = import price in the current year Px0 = export price in the base year Pm0 = import price in the base year lliustration (a) Assuming that, Px1 = 180 and Pm1 = 150, then the net barter terms of trade will be: Px 0 Px Tc = 1 x x100 Pm1 Pm0
International Trade and Finance - I 7 Gains from Trade

(i)

(a)

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

180 100 x 150 100 Tc =120 It implies that the net barter terms of trade has improved by 20 percent in the current year compared with the base year. Tc = (b) Assuming that Px1 = 140 and Pm1 = 160, Tc will be: 140 100 x =87.5 150 100 In this case, compared with the base year, in the current year the T c has deteriorated by 12.5 per cent. Thus, a rise in the index represents an improvement in the T c while a fall in the index denotes a deterioration in the Tc.

Limitations: The concept of net barter terms of trade is subject to the following limitations: (1) Various problems are involved in the construction of index numbers. (2) It does not consider the quantity of exports and imports. (3) It overlooks qualitative changes in output. . (4) This concept can sometimes result in misleading conclusions. (5) It is unsuitable for explaining the distribution of gains from trade. (6) It neglects factors affecting the prices of exports and imports. (7) It does not throw light on the behaviour of balance of payments. (8) This concept does not explain the capacity to import. (b) Gross Barter Terms of Trade This concept has been introduced as an improvement upon the concept of Net Barter Terms of Trade which suffers from certain limitations. Gross Barter Terms of Trade represents the ratio of total physical quantities of imports to the total physical quantities of exports of a given country. Symbolically, Qm Tg = x100 Qx Where Tg = gross barter terms of trade Qm = total quantity of imports, and Qx = total quantity of exports If we want to measure changes in the gross barter terms of trade from one period to another the formula will be:

International Trade and Finance - I

Gains from Trade

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

Tg =

Qm1 Qx1 x x100 Qx1 Qx 0

(i)

Where Om1 = quantity of imports in the current year Qx0 = quantity of imports in the base year Qx1 = quantity of exports in the current year Qx0 = quantity of exports in the base year Assuming that in the current year Qm1 = 150 and Qx1 = 125, Tg will be, Qm1 Qx1 Tg = x x100 Qx1 Qx 0 150 100 Tg = x x100 125 100 Tg =120 It means that as between the base year and the current year there is an improvement in Tg to the extent of 20 per cent. Assuming that in the current year, Qm1 = 120 and Qx1 = 180, Tg will be, 120 100 Tg = x x100 180 100 Tg =66.67percent It implies that between the base year and the current year, T g has deteriorated by 33.33 per cent. It may be noted that in case of equilibrium in the balance of trade, there will be equality of net and gross barter terms of trade, otherwise the two concepts will be different. .

(ii)

Limitations The concept of Gross Barter Terms of Trade is criticized on the following grounds:(1) The aggregation of goods, services and capital transactions is considered to be unreal and impractical. (2) This concept is a faulty index of welfare because it ignores changes in tastes and habits of the people. (3) It has overlooked the impact of improvement in productivity. (4) This concept also does not explain the capacity of a country to import. (5) It fails to consider qualitative improvements in production in the trading countries concerned. (6) It has not considered capital movements which have a significant impact on balance of payments. The concept of Net Barter Terms of Trade is superior to the concept of Gross Barter
International Trade and Finance - I 9 Gains from Trade

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

(c)

Terms of Trade. Income Terms of Trade The concept of Income Terms of Trade has been contributed by G.S.Dorrance and H. Staehle. This concept has been an improvement upon the concept of commodity or Net Barter Terms of Trade. This concept considers the indices of export and import prices and quantity index of exports. It is determined by the product of net barter terms of trade and the quantity index of exports. The formula is, Ti = Tc. Qx Where Ti = income terms of trade Tc = net barter terms of trade Qx = quantity index of exports. Px Since Tc = , Ti can be expressed as, Pm P Tc = x x Q X Pm The concept of Income Terms of Trade is called 'Export Gain from Trade' by A.H.Imlah .

lllustration (i) Assuming that in the current year Px = 96 Pm = 144, and Qx = 162, then the income terms of trade will be: P Ti = x x Q x Pm 96 Ti = x162 144 Ti =108 It means that there is an improvement in the income terms of trade to the extent of 8 per cent. Assuming that in the current year Px = 114 Pm = 96, and Qx = 80, then The income terms of trade will be:
10 Gains from Trade

(ii)

International Trade and Finance - I

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

Px x Qx Pm 114 Ti = x 80 96 Ti = Ti =95 It means that the income terms of trade has deteriorated by 5 per cent. The significance of the concept of income terms of trade lies in that it throws light on the capacity of a country to import. The capacity of a country to import increases when, (a) there is a rise in the quantity exported (b) there is a rise in export prices (c) there is a fall in prices of imports The concept of income terms of trade is particularly relevant to the less developed economies which face the problem of low export price and high import price. Limitations The concept of income terms of trade is criticized on the following grounds: (1) This concept is not an accurate measure of gain from international trade. (2) It is not a measure of total capacity of a country to import. It is based on export based import capacity. (3) This concept cannot replace the concept of net barter terms of trade. (4) It is misleading as an indicator of welfare gain from international trade. (ii) On the basis of changes in factor productivity On the basis of changes in factor productivity, Jacob Viner has classified terms of trade into, (a) Single Factoral Terms of Trade (b) Double Factoral Terms of Trade Single Factoral Terms of Trade This concept takes Into account changes in productivity of the factors of production used in export industries. It is obtained by multiplying ne~ barter terms of trade by the productivity index in domestic export sector. Symbolically, Ts = Tc x Fx Where Ts = Single factoral terms of trade Tc = net barter terms of trade Fx = index of productivity in domestic export sector
11 Gains from Trade

(a)

International Trade and Finance - I

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

Since we know that Tc = Ts =

Px , we can express single factoral terms of trade as: Pm

Px xFx Pm If we want to measure changes in the single factoral terms of trade from one period to another, then the formula will be P F Ts = x x x0 Pm Fx1 The concept of single factoral terms of trade is of much importance to the developing economies. Illustration (1) Assuming that in the current year, Px = 130 Pm = 160 Fx = 140, Then single factoral terms of trade will be: P Ts = x xFx PM 130 Ts = x140 160 Ts =113.75 It means that there is an improvement in the single factoral terms of trade by 13.75 per cent. But, it may be noted that there is deterioration in commodity terms of trade. Assuming that in the current year, Px = 120 Pm = 110 Fx = 88, then single factoral terms of trade will be P Ts = x xFx Pm 120 Ts = x 88 110 Ts =96 This implies that between the base year and the current year, there is a deterioration in the single factoral terms of trade by 4 per cent. It means an improvement in the net barter terms of trade.
International Trade and Finance - I 12 Gains from Trade

(2)

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

Limitations (1) It is very difficult to measure productivity. (2) This concept does not consider changes in productivity ofthe factors used in import industries. (3) It is not a reliable index of gain from international trade. (4) We cannot overlook the problem of increasing global inequalities. The concept of single factoral terms of trade cannot be an appropriate index of welfare. (b) Double Factoral Terms of Trade Viner introduced this concept as an improvement upon his concept of single factoral terms of trade. The concept of Double Factoral Terms of Trade considers changes in the productivity of the factors used in both export and import industries. The concept of Double Factoral Terms of Trade is derived by multiplying the single factoral terms of trade by the index of the productivity of the factors used in the import industries. Symbolically, Fx Td =Tc x Fm Where Td = double factoral terms of trade Tc = commodity terms of trade Fx = index of productivity of factors used in export industries Fm = index of productivity of factors used in import industries Px x100 double factoral terms to trade could also be expressed as, Since Tc = Pm P F Td = x , x x100 Pm Pm

Illustration: Assuming that in the current year Px = 140 Pm = 130 Fx = 150, and Fm = 125, then P F Td = x , x x100 Pm Pm 140 150 Td = x x100 130 125 Td =129.33 Thus, double factoral terms of trade has improved by 29.23 per cent over the base period.
International Trade and Finance - I 13 Gains from Trade

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

Limitations The following are the limitations of double factoral terms of trade: (1) There is the problem of the measurement of productivity. (2) There is misplaced emphasis on the relative productivity indices in the two trading countries. (3) It is a faulty concept. Kindleberger objects to the relationship between the productivity of the factors in two trading countries. (4) This concept does not help to determine the gains from trade. (5) It ignores real costs as a factor influencing the terms as well as the gains from international trade. (Ill) On the basis of utility analysis we have the two - fold classification of terms of trade. They are, (a) Real Cost Terms of trade, and (b) Utility Terms of Trade (a) Real Cost Terms of Trade: This concept has been introduced by Jacob Viner. Real cost refers to the amount of utility lost or sacrificed per unit of resources employed in the production of exports. Real cost terms of trade can be measured by multiplying the single factoral terms of trade by the index of the amount of disutility per unit of the resources employed in producing export goods. Symbolically, Tr = Ts. Rx Where Tr = real cost terms of trade Ts = single factoral terms of trade, and Rx = index of this utility caused per unit of resources employed in the production of export goods. Px x Fx , real cost terms of trade can be expressed as Since Ts= Pm Px Tr = . Fx.Rx Pm This concept is considered to be better as a measure of real economic welfare or gains from trade.

Limitations The concept of real cost terms of trade is subject to the following limitations: (1) It is a subjective concept. Hence, it can not be precisely measured in objective terms. (2) It does not consider the real cost involved in diverting the goods being used for .domestic consumption to supplement exports for paying the imports. (3) It neglects the real cost of producing import - substitutes.
International Trade and Finance - I 14 Gains from Trade

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

(b)

Utility Terms of trade: Viner has introduced this concept to overcome the limitations of the concept of real cost terms of trade. This concept is obtained by multiplying the Real Cost terms of Trade by the index of the relative utility of imports and the foregone commodities. Symbolically, Tu = Tr. U When Tu = utility terms of trade Tr = real cost terms of trade, and U = index of relative utility of imports and domestic goods foregone The utility terms of trade can be expressed in terms of the commodity terms of trade or the net barter terms of trade as under: Tu = Tr.U Tr = Ts.Rx Ts = Tc. Fx Therefore, Tr = Th. Fx. Rx and Tu = Tc. Fx. Rx. U It may be noted that an increase in U results in the deterioration of utility terms of trade and vice - versa. D.H. Robertson calls the utility terms of trade the "true terms of trade". The limitation of this concept lies in that, like the concept of real cost terms of trade, this concept also is subjective. As such, it can not be precisely measured in objective terms. In conclusion, it may be noted that the concepts of single factoral, double factoral, real cost and utility terms of trade have more of academic interest than practical interest. In order to measure the gains from .international trade, for all practical purposes, the concepts of commodity terms of trade and income terms of trade have much relevance. Factors Affecting the Terms of Trade Various factors determine or influence the terms of trade of the trading countries concerned. These factors are discussed below: Reciprocal demand This concept, put forth by J.S. Mill, indicates the intensity of demand for the product of one country by the other. This concept could be explained with an example. If the demand for country ~s cloth is more intense (or inelastic) in country B, country B will offer more units of its product, let us say steel, to import a given quantity of cloth. On the contrary, if the demand for cloth in country B is less intense (elastic) then country B will offer smaller quantity of steel to import the given quantity of cloth. Further, if the reciprocal demand for steel in country A increases, it will be willing to' offer more quantity of cloth for the given import of steel. On the contrary, if the
15 Gains from Trade

2.7

(1)

International Trade and Finance - I

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

(2)

(3)

(4)

(5)

(6)

reciprocal demand for steel in country A decreases, it will offer lesser quantity of cloth to offer the same quantity of steel. In the former case, the terms o ftrade is worsened while in the latter case it gets improved for country A. In the case of country B if there is an increase in its reciprocal demand for cloth, the terms of trade will be favourable. But, if there is a decrease in reciprocal demand for cloth in country B will lead to a deterioration in its terms of trade. Tariff When a country imposes tariff on imports from the foreign country, it means a lesser willingness to absorb the foreign products. It implies that the reciprocal demand in the tariff imposing country for the foreign product has got reduced. Tariffs are, therefore, likely to improve the terms of trade for the tariff - imposing country. Changes in tastes Changes in tastes influence the terms of trade of a country. For example, if tastes or preferences of the people in country A shift from the product Y of country B to its own product X, country A will enjoy a favourable terms of trade. In the opposite situation, country A will suffer from an adverse terms of trade. Changes in Factor Endowments Another determinant of the terms of trade of a country is changes in the factor endowments. For example, if there is an increase in the supply of labour in country A, specializing in the production of labour - intensive commodity cloth, while factor resources in country B remain unchanged, the fall in labour cost will reduce the price of cloth. Hence, more quantity of cloth will be offered by country A for the same quantity of steel, resulting in unfavourable terms of trade to country A. On the contrary, if in country A the supply of labour becomes scarce, it will enjoy a favourable terms of trade. Changes in Technology Changes in the techniques of production influence the terms of trade of a country. If there are technological changes, let us say, in country A, there will be a rise in productivity and / or a fall in thecost of producing exportable commodity, say, cloth. If technological progress is labour - saving in the cloth industry, the terms of trade will be worsened for country A. On the contrary, if technological progress is import competing, there will be improvement in the terms of trade. Further, if capitalsaving technical progress takes place in labour - intensive export sector, there can still be the possibility of improvement in the terms of trade. Economic Growth Economic growth is another factor which influences the terms of trade of a country. Economic growth leads to a rise in the real. national product or income of a country over a long period. There will be an increase in per capita income also. The effect of economic growth on the terms of trade of a country depends upon the effect of growth on the net demand for imports. On the one hand, by increasing the level of income, economic growth leads to an increase in the demand for imports. On the other hand, economic growth leads to an increase in the supply of domestic goods which otherwise will have to be imported. Now the net effect of economic
16 Gains from Trade

International Trade and Finance - I

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

(7)

(8)

(9)

(10)

growth on the terms of trade is the combined result of these demand and supply effects. If the demand effect is more, the terms of trade will be unfavourable and if the supply effect is more, the terms of trade will be favourable. Devaluation Devaluation refers to a deliberate reduction in the external value of a currency. Devaluation results in a rise in import prices and a fall in the export prices, leading to a deterioration in the terms of trade of the country concerned. Whether the terms of trade becomes favourable or unfavourable, because of devaluation, depends upon the elasticities of demand for and supply of exports and imports of the devaluing country. It may be noted that if the elasticities of supply of exports and imports are higher than the elasticities of demand for exports and imports, there will be worsening of terms of trade after devaluation. Secondly, in case the product of elasticity co-efficients related to demand for exports and imports is exactly equal to their supply, the terms of trade of the devaluing country remains unchanged. Finally, if the product of elasticity co-efficients of demand for exports and imports is' greater than the product of elasticity co- efficients of supply of exports and imports, devaluation leads to an improvement in the terms of trade of the country concerned. Balance of Payments Position If a country is in a deficit position in its balance of payments and adopts restrictions to reduce imports, its terms of trade will be worsened. But a country which has a surplus in its balance of payments will have a favourable terms of trade. International Capital Flows An increase in the inflow of capital from other countries creates larger demand for the products of the creditor country. With the result, there will be a rise in the prices of imported goods leading to a deterioration in the net barter terms of trade. When the borrowing country makes repayments of outstanding loans, there will be outflow of capital. In' order to earn required foreign exchange to make repayments, homeproduced goods will be sold at low prices leading to a fall in export prices. The fall in export prices relative to import prices will again account for the deterioration in the net barter terms of trade. Import Substitutes If a country produces import substitutes it will have a favourable terms of trade. If in a country import substitutes are not available it will suffer from an unfavourable terms of trade. In addition to the above factors, other factors determining the terms of trade of a country include the following: price movements business cycles transfer problem, and political conditions, etc.
17 Gains from Trade

International Trade and Finance - I

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

Rx== index of utility this caused utility caused Rx index of this per unit ofper unit resources employed of in the production
of

resources employed in the production of export goods. export goods. Rx =x Fx, index of this utility caused per = ..h. x Fx, real cost terms of be trade = ..h. real cost terms of trade can Pm unit of can be expressed as: employed in the resources Pm production of expressed as: export goods. = ..h. x Fx, real cost terms of trade can be Pm expressed as: QUESTIONS SECTION - A (4 Marks Ouestions) Measurement of gains from trade. Net Barter Terms of Trade. Single Factoral Terms of Trade Reciprocal Demand Potential Gain and Actual Gain SECTION - B (8 Marks Questions) Explain the static and dynamic gains of international trade. Explain the concepts of Net Barter Terms of Trade and gross Barter Terms of Trade. Distinguish between Single Factoral and Double Factoral Terms of trade. What are the factors determining the gains from international trade? SECTION - C (16 Marks Questions) What do you mean by Terms of Trade? Explain the different concepts of Terms of Trade. Discuss the various factors determining the terms of trade of a country.

1. 2. 3. 4. 5.

1. 2. 3. 4.

1. 2.

International Trade and Finance - I

18

Gains from Trade

F.Y.B.COM.

MAHESH COLLEGE OF MANAGEMENT

Rx = index of this utility caused per unit of resources employed in the production of export goods. = ..h. x Fx, real cost terms of trade can be expressed as:
Pm

International Trade and Finance - I

19

Gains from Trade