©0427950162 WINNERS DON'T DO DIFFERENT THINGS, THEY DO THINGS DIFFERENTLY NEERU CLASSES FOR ALL SUBJECTS OF 11TH, 12TH & F.Y., S.Y., T.Y. B.COM 2nd Floor, Shri Ram Complex, Harni Warasia Ring Road, Near Kalavati Hospital, Vadodara - 390006 T.Y. B.COM (SEM - V) - INTERNATIONAL TRADE (IT) UNIT -1 THEORIES OF INTERNATIONAL TRADE This study material covers: icance of International Trade Distinction between internal and external trade Classical theories of International Trade Doctrine of Reciprocal Demand “2 Offer Curve Analysis | INTRODUCTION TO INTERNATIONAL TRADE | Q.1 Explail is of i - - other. OR Explain the basis of trade. Why trade arises between two countries? OR Do you agree that international trade results due to different factor endowment of various countries? Explain. OR What are the causes (factors responsible) for international trade. (A) Basis of International Trade (Why do nations trade?):- (1) A country can not produce all the goods & services within @ country. So, it can_not satisfy all the needs of people. To satisfy variety of needs of people it must import certain goods from other countries. (2) The natural resources, climatic conditions labour & capital resources technical capacity etc are different in different countries Further, the resources of a country are more suitable for production of certain goods. So, they can produce these goods at lowest cost of production e.g. Japan can produce automobile goods ad electronic goods at comparatively lower cost. So, it has specialized in the production & export of automobile & electronic goods. In exchange of such goods, it imports other goods from other countries. (3) Usually, a country will specialize in the production of that commodity, in_which it has absolute or a comparative advantage. It will export its surplus production to other countries and will import that, commodity in which it has no such advantage. Thus international trade arises due to cost advantage (or benefit or gain) Thus cost advantage is the basis of international trade. If there is no benefit or gain from trade there will not be international trade. NAL TRADENEERU CLASSES (8) Causes International Trade (What gives rise to International Trade):- International trade arises due to differences in the prices of goods in different countries. Further, Price difference arises due to the difference in demand conditions or supply conditions or both. (1) Differences in Supply Conditions:- Differences in supply conditions arises due to difference in supply of natural resources, \abour and capital resources, efficiency, technology, etc. Because of different supply conditions, the production capacity of different countries are different. So, their production costs and selling prices of goods and services are also different. (2) Differences _in Demand Conditions: Differences in demand conditions arises due to difference in income, and taste & preference of people. If two countries are producing same commodity at the same cost of production, it is not necessary that prices may be same in both the countries. If a country has a higher level of income and people have strong preference for the product, its price may be higher. Thus, difference in demand conditions results into price differences and price difference give rise to international trade In short, international trade takes place because of the difference in prices. Price difference arises because of difference in supply conditions or demand conditions, or both. To Explain the basis (or causes) of international trade, let us study following diagrams: Diagram LA Diagram 12 Foreign Country Home Country Forcign Country Home Country Expos 1 nf ° alo a Identical demand conditions but Identical Supply conditions but different supply conditions different demand conditions Diagram € agra Foreign Country Home County Foreign Country Home Country Expats a Pe ay » . e af a. a Different demand conditions but Identical Supply conditions and different supply conditions Tdenticaldemand conditions THEORIES OF INTERNATIONAL TRADE 2A.2. NEERU CLASSES (1) Price in the foreign country (P-) is lower than the price in the home country (P.). This price difference (P,, > P-) is due to - Different supply conditions as in diagram No. (1-A.), oF - Different demand conditions as in diagram No.(1-B), 0 - Different in demand and supply conditions as in diaoram No. (1-C) In all the three diagrams, price in foreign country is Pr. It is lower than price in_home country which is Py. So, home country will import this commodity from foreign country. Thus, it is the price difference, which gives rise to international trade (2) Such trade will continue, so long as there is price difference. But, when the price difference disappears, there will be no international trade. This is clear from diagram No.1-D. In this diagram, the demand and supply conditions of home country are exactly equal to the demand and supply conditions of the foreign country. So, price is equal in both the countries. So, international trade will not take place. - Distinquish between national (Internal) trade and international trade. OR Explain briefly the major differences between domestic trade & foreign trade. Internal trade (Domestic trade) means exchange of goods and services among the residents of the same country. But, international trade (foreign or external trade) means exchange of goods and services between the residents of one country and the countries of the rest of the world. Following are the main points of distinction between internal trade and external trade. Internal trade International trade (1) Factor Mobility: (a) Within a country, factors of| (a) In case of international trade, the production are easily transferable. | degree of factor mobility is less. This is So, degree of factor mobility is| because, there are certain restrictions greater within a country (like immigration laws, citizenship (b) Due to greater degree of factor | requirements, etc) on the movement of mobility, within a country, factors of | labor. Similarly, there are certain production can easily move from the| restrictions on movement of capital and place, where their prices are lower, | foreign investment. to the place, where their prices are | (b) Due to less mobility of factors of higher. So, in long-run, factors| production, the factor prices are prices will be the same throughout the | different in different countries. country. (2) Product Mobility: Within a country, goods and services | In case of international trade there are are easily transferable. So the degree | certain restrictions on the movement of product mobility is greater. of goods (such a custom duty / import quota). So, the degree of product mobility is less. (3) Market: Within a country, the markets are|In case international trade, the homogeneous, because the culture, | markets are heterogeneous. This is language, customs and taste and|because the /anguage, culture, preference of people may be the| customs and taste and preference of same. people are different in different countries. THEORIES OF INTERNATIONAL TRADE 3(4) National Group: In internal trade, | group. (5) Political Unit: trade takes place among the people of same national Internal trade takes place within the same political unit, which has it own NEERU CLASSES International trade take place among the people of different national groups. International Trade take place between different political _units. Who have currency. commercial policy. different_commercial policies. Each country tries to protect its own interest at the cost of the other country. (6) Monetary unit: Within a country, the monetary | In international trade, there is a use of system and financial system are the same. So, there is a use of only one different currencies \ike dollar, rupees and pound, etc. further, all the currencies may net be acceptable by all the countries. the same. E.g Within a country the political and economic environment are almost the Jaws governing consumption, production and exchange of goods are the same throughout the The political and legal environment are different in different countries. E.g the Jaws governing production, consumption and exchange of goods as well as the government policies county. Similarly the government | regarding wage, interest rates and policies regarding wages, interest rates prices are different in different and prices are the same within the | countries. country. THEORIES OF INTERNATIONAL TRADE 4ts ic} NEERU CLASSES [ CLASSICAL THEORY OF INTERNATIONAL TRADE | Po pe Introduction :- The classical theory of international trade was first developed by Adam Smith, who introduced the principle (theory) of Absolute Cost Advantage. It was further developed by David Ricardo, who introduced the principle (theory) of Comparative Cost Advantage. Both the models are known as supply version of the Classical Theory of International Trade, because they give more attention to only supply or production cost, in determination of terms of trade and gains from trade Assumption: - This theory is based on the following assumptions (1) There are two countries, producing two commodities, (2) Labour is the only factor of production. (3) Labour is perfectly mobile within a country but immobile internationally. (4) Labour is homogeneous. (5) Cost of production is measured in terms of labour units (labour hour). (6) There is free trade i.e. there are no restrictions (trade barriers) on trade. (7) There is perfect competition (8) There is a constant return to scale (constant cost conditions). (9) There is full-employment equilibrium. "adam Smith has developed the theory of Absolute cost advantage According to this theory - (1) Absolute cost advantage is the basic of international trade. (2) A country will specialize in the production and export of that commodity in which it has absolute cost advantage. Further, it will import that commodity in which it has no such advantage. Let us explain this with the help of an example. Assumptions ~ Suppose (i)There are only two countries - India & Malaysia, producing two commodities - Rubber & Textiles. (ii) There is constant returns to scale (or constant cost conditions) (iii) Both the countries can produce both the goods. (iv) Both the countries have certain amount of factors of production (a) Suppose, out of available resources, Malaysia can produce either 100 units of cloth or 50 units of rubber. (b) Similarly, India can produce either 50 units of cloth or 100 units of Rubber. Following table shows the production possibility in both the countries Possible Level of Production (in units) Country Rubber | Cloth | Domestic Exchange Ratio Malaysia 100 50 2R = 1C India 50 100 1R = 2C In this case, = Malaysia has absolute (cost) advantage in the production of Rubber and India has absolute cost advantage in the production of cloth. => Therefore, Malaysia will specialize in the production & export of Rubber and India will specialize in the production & export of cloth. = So, there is scope for specialization and mutually beneficial trade between the two countries. THEORIES OF INTERNATIONAL TRADE 5NEERU CLASSES - Now, let us compare production and consumption level of both the countries — before trade and after trade. ~ If there is No Trade (situation of Autarky) :- following table shows production and consumption before table. con wi Country Commodities Total Output or GNP Rubber (units) | Cloth (units) (units: India 50 25 75 Malaysia 25 50 75. World 75 75 150 This table shows that before trade total output of both the countries is 75 unit. Production after trade: Now, if there is trade between both the countries, India will specialize in production of cloth and Malaysia will specialize in the production of rubber. Now, their total output will be as follow: Production Levels after International Trade Country Commodities Total Output or GNP Rubber (units) | Cloth (units) (units) India 100 0 100 Malaysia oO 100 100 World 100 100 200 This table shows that: (1) Before trade, total production of Malaysia and India was 75 unit. But after trade, their production is 100 units. Thus as a result of international trade, there is increase in production by 25 units in both the countries. (2) As a result of trade, world production increases from 150 units of 200 units. This is production gain from international trade. “« What about Consumption Gains of Trade :- The consumption gain from trade depends upon the international terms of trade (rate of exchange between two countries). Here, we should consider following two principles. (1) If the international terms of trade are between the domestic exchange ratios of two countries, both the countries will gain from international trade. (2) If the international terms of trade are equal to the domestic exchange ratio of a country, it will not get gain from international trade. Now, let us examine following possibilities. (A) Suppose, the Terms of Trade are fixed at 1: 1 (1 unit of rubber = 1 unit of cloth) :- Suppose, Malaysia and India agrees to exchange 1 unit of rubber for 1 unit of cloth. Now, consumption gain depends upon their trade pattern. The total production of Malaysia is 100 units of rubber. Suppose, it desires to retain 60 units of rubber for self-consumption. So, it desires to retain 60 units of rubber for self-consumption. So, it decides to export 40 units of rubber to India at the exchange rate of 1: 1. In exchange of 40 units of rubber, it gets 40 units of cloth. So, after trade, consumption of both the countries will be as follow ; Consumption Shares after International Trade Country Commodities Total Output or GNP | Consumption Rubber (units) | Cloth (units) (units) Gain (units) Malaysia 60 40 100 25 India 40 60 100 25 World 100 100 200 50 THEORIES OF INTERNATIONAL TRADE 6NEERU CLASSES This table shows that - = Now, in India, after trade, consumption of rubber is 40 units and that of cloth is 60 units (total 100 units). But, before trade, it was 25 units and 50 units (total 75 units). So, its consumption gain is 25 units. = Similarly, in Malaysia, after trade, consumption of rubber is 60 units and that of cloth is 40 units (total 100 units). But, before trade, it was 50 units and 25 units (total 75 units). So, its consumption gain is 25 units. Here, the consumption gain of both the countries is equal, when terms of trade are 1: 1. This exchange ratio fall exactly between internal exchange ratios in the two countries. So, the consumption gains of both the countries are equal. However, an actual gain from trade depends upon the terms of trade. (B) Suppose, the Terms of Trade are fixed at 2 : 1 (2 unit of rubber = 1 unit of cloth) :- Now, suppose, Malaysia desires to retain 50 units of rubber for self- consumption. Now, at the new terms of trade of 2 : 1, it exports 50 units of rubber and gets 25 units of cloth in its exchange. So, now, the consumption level will be as follow : Consumption Shares after International Trade ‘Country Commodities Total Consumption | Consumption Rubber (units) | Cloth (units) (units) Gain (units) Malaysia 50 25 25 00 India 50 75 25 50 World 100 100 50. 50 = Now, in Malaysia after trade total consumption is 50 units of rubber and 25 units of cloth (total 75 units). Now, before trade also, its total consumption was 75 units. So, the consumption gain of Malaysia is zero. = After trade, in India, total consumption is 50 units of rubber and 75 units of cloth (total 125 units). But, before trade, its total consumption was 75 units. So, the consumption gain of India is 50 units. This means, if the terms of trade are 2 : 1, they are favorable to India, but extremely unfavorable to Malaysia. The reason is - the terms of trade (2 ; 1) are exactly equal to the internal cost ratio (domestic exchange ratio) of Malaysia. (C) Suppose, the Terms of Trade are fixed at 1 ; 2 (1 unit of rubber = 2 unit of cloth) :- Suppose, out of total production of 100 units of cloth, India desires to retain 50 units for self-consumption. Now, at the terms of trade of 1 : 2, it exports 50 units of cloth & gets 25 units of rubber. Now, the consumption level will be as follow: Consumption Shares after International Trade Commodities Total Consumption | Consumption Country Rubber (units) | Cloth (units (units) Gain (units: Malaysia 75 50 25 50 India 25 50 25 00 World 100 100 50 50 In this case - = After trade, total consumption of India is 75 units (25 units of rubber and 50 units of cloth). Before trade, also, its total consumption was 75 units. So, its consumption gain of India is zero = The total consumption of Malaysia is 125 units (75 units of rubber and 50 units of cloth). But before trade, it was 75 units. So, its consumption gain is 50 units. Thus, the terms of trade are 1 : 2, they are favourable to Malaysia and unfavourable to India, The reason is the international terms of trade are exactly equal to internal cost ratio (domestic exchange ratio of India) THEORIES OF INTERNATIONAL TRADE 7Q.2. A2. NEERU CLASSES Conclusions :- From the above discussion we can conclude that - (1) International trade cannot take place if cost ratios of two countries are same. (2) Trade takes place, if there is absolute cost difference between two countries. (3) The gains from trade depend upon the terms of trade. (4) If the terms of trade lies somewhere between the internal cost ratios/domestic exchange ratios of two countries, both the countries will get gains from trade. (5) If the terms of trade are closer or nearer to the domestic exchange ratio of a country,, it will gain less. (6) Production gains are not alone sufficient to determine the profitability of international trade. (7) Consumption gains are more important in determining the gains in terms of welfare of standard of living of people. In this way, Adam Smith showed that how both the countries will gain from international trade. Limitation of Absolute Cost Advantage Theory: This theory is not convincing, because it is based on the assumption that one country must have absolute advantage over the other country in one line of production. But in reality many underdeveloped countries may not have absolute cost advantage over the developed countries in any commodity. But even then, they enter into international trade. This theory clearly fails to analyze such situations. David Ricardo has developed the theory/principle of comparative cost advantage. This model/theory is a refinement of Adam Smith's model. According to this theory : (a) It is the comparative cost advantage, which is the basis of international trade. (b) International trade can be beneficial even if the countries do not have absolute (cost) advantage in any line of production over the others. According to the theory of comparative cost advantage, the country will (should) specialize in the production and export of that commodity, in which it has = Comparatively greater cost advantage, or = Comparatively least cost disadvantage. It will import that commodity in which it has comparatively higher cost disadvantages. Assumptions - (a) There are two countries - Malaysia and India (b) They produce two commodities - Rubber and Cloth. (c) Both the countries can produce that both the goods (d) Both the countries have certain amount of factors of production Now, suppose ~ (i) Out of available resources, India can produce 120 units of cloth or 120 units of rubber or any combination of cloth and rubber. So, the cost ratio or domestic exchange ratio (internal terms of trade) is 1: 1. Malaysia can produce 40 units of cloth and 80 units of rubber. So, its domestic exchange ratio is 1: 2. This production possibility is given in the following table : THEORIES OF INTERNATIONAL TRADE 8NEERU CLASSES country Commodities Domestic Exchange Cloth (units) | Rubber (units) Ratio india 120 120 1:14: 4) Malaysia 40 80 1:2(2: 4) y, This table shows that - soot (1) India__has_~— absolute _cost advantage in the production of both the commodities. But, it has comparative 80) greater cost advantage in the production 5 & of cloth. So, it should specialize in the B a production and export of cloth. a (2) Similerly, Malaysia hes absolute cost disadvantage in production of both the goods. But, it has comparatively less 3 disadvantage in the production of rubber. a a 35x 0, It should specialize in the production and export of rubber. Cloth Pp Production Gains from Trade - To measure production gain, let us compare production of both the countries before trade and after trade. This is shown by table 1 & Table -2. Production and Consumption with Zero Trade [country Commodities Total production and Cloth (units) | Rubber (units) | consumption (units) India 60 60 120 Malaysia 20 40 60 World 80 100 180 Production and Consumption after Trade Country Commodities Total production and Cloth (units) | Rubber (units) | _ consumption (units) India 120 0 120 Malaysia o 80 80 World 120 80 200 This table shows that - (1) As a result of international trade, production of Malaysia increases by 20 units, but production of India remains the same. (Here, small country may get more benefits in terms of production). (2) World production increases by 20 units. This is entirely due to the production gain of Malaysia. Consumption gain to Trade :- The consumption gain from international trade depends upon the international terms of trade (the rate of exchange between two countries or international cost ratio) Here, it should be remembered that: (1) If the international terms of trade are between the domestic exchange ratio of two countries, both the countries will gain from trade. (2) If the international terms of trade is equal to the domestic exchange ratio of as country it will not gain from trade. Now, let us examine following possibilities. THEORIES OF INTERNATIONAL TRADE 9NEERU CLASSES (A) Suppose, the International Terms of Trade between India and Malaysia are 3 : 4 (3 unit of cloth = 4 unit of rubber) :- Suppose, out of 120 units of cloth, India decides to consume 90 units and exports 30 units to Malaysia. In exchange of 30 units of cloth, it gets 40 units of rubber. So, after trade, the consumption of both the countries will be as follow Consumption Levels after Trade Country ‘Commodities Total consumption Gains in Cloth (units) | Rubber (units) (units) Consumption (units) India 90 40 130 10 Malaysia 30 40 70 10 World 120 80 200 20 In this case, the consumption gain of both the countries increases by 10 units. Thus if the international terms of trade are between the domestic exchange ratio of two countries, both the countries will get consumption gain. (B) Suppose, the International Terms of Trade are 1; 2 (1 unit of cloth = 2 unit_of rubber) :- If the international terms of trade are 1:2 the whole consumption gain will go to only India & Malaysia will not get consumption gain. This is because, the international terms of trade is exactly equal to the domestic exchange ratio of Malaysia. This is clear from following table: ; Country Commodities Total consumption Gains in Cloth (units) | Rubber (units) (units) Consumption (units) India 100 40 140 20 Malaysia 20 40 60 0 World 120 80 200 20 (C) Suppose, the International Terms of Trade are 1: 41 (1 unit of cloth = unit of rubber) :- If the international terms of trade are 1:1 the whole sensumation_oain will go get consumption to Malaysia_but India will not gain. This is because, the international terms of trade is equal to the domestic exchange ratio of India. This is clear from following table: Consumption Levels after Trade Country Commodities Total consumption Cloth (units) | Rubber (units) (units; Consumption (units) India 80 40 120 0 Malaysia 40 40 80 20 World 120 80 200 20 (2) “ Critical Evaluation / Criticisms :- This theory has been criticized on following grounds @) i- This theory is based on labour theory value, which itself is defective and it is based on unrealistic assumptions. This is theory is assumes labor is the only factor of production. So, it measures cost of production in real terms (i.e. in terms of only labor units). But in fact, labor is not the only factors of production. There are also other factors of production such as capital and organisation. Assumption of Mobility and Immobility of Labour :- This theory is based on an assumption that labour is perfectly mobile within a country and immobile THEORIES OF INTERNATIONAL TRADE 10ic} (3) (4) (5) (6) 7) (8) (9) Q3. A3. NEERU CLASSES between the countries. But, this is not correct. In reality, even within the Same country also, labour is not perfectly mobile. Money Cost :- In money economy, it is mot proper to express cost of production in real terms (labour units). It should be in terms of money i.e. money cost. Assumption of Constant Return to Scale :- This theory assumes constant returns to scale (constant cost condition) which is unrealistic. i+ This theory assumes perfect competition, which does not exist in the real world Further, it’ assumes free trade. But, in reality, there are many restrictions on imports. Assumption of Full-employment :- This theory is based on the assumption of full employment situation. But this is not correct. (In reality, full employment situation does not exist in real world). Ignores Transport Cost :- This theory is ignores transport cost. But, transport cost constitutes a sizable portion of cost involved in international trade. Some time, the transport costs may be greater than the comparative cost advantage. Basis of Trade :- This theory argues that trade arises due to comparative cost difference. But, it does not explain why comparative cost difference arises. Complete Specialisation: According to Graham comparative cost advantage may not lead to complete specialisation, when one country is small and the other is big. Bring wit the difference between absolute cost & Comparative cost advantage model. (1) Theory of absolute cost advantage was developed by Adam Smith But comparative cost advantage theory was developed by David Ricardo (2) Absolute cost advantage theory considers division of labour while comparative cost advantage theory considers labour theory of value (3) According to absolute cost advantage trade occurs between two countries if one of them has an absolute cost advantage in producing one commodity But according to comparative cost theory, international trade takes place because different countries have different advantage in the production of different commodities. (4) Principle of Comparative Cost advantage is an extension of principle of the division of labour. It explains geographical specialisation. This, it is an improvement over of absolute cost advantage. (5) The gain from trade depends upon the terms of trade. In the theory of Absolute cost advantage both production & consumption gains are important in determining welfare of member countries. While in the theory of comparative cost advantage, mutually beneficial trade between the two countries can take place only when both countries has some consumption gains. THEORIES OF INTERNATIONAL TRADE unNEERU CLASSES THEORY OF RECIPROCAL DEMAND D 1 F recit * Q.1. Di "7 i inati ? OR terms of trade are determined by Reciprocal demand. Explain this with the help of offer curve analysis. A.1. Introduction :- The principle of reciprocal demand was developed by J.S.Mill. Later on, offer curve technique was developed by Edgeworth & Marshall. The offer curve explains - how the terms of trade are determined by the Suppose, there are two countries - country A and B, & two commodities cloth and rubber. In this case, according to the law of reciprocal demand, the terms of trade are determined by A’s demand for B’s product, and B's demand for A’s product. In other words, the terms of trade are determined by the intensity of domestic demand for foreign goods and that of the foreian demand for domestic goods. e.g. if there are two countries - A & B, then the offer curve of country - A, shows the intensity of domestic demand for goods of country ~ B, and the offer curve of country ~ B shows the intensity of demand for the goods country ~ A. To explain the law of reciprocal demand, Edgeworth & Marshall have developed the technique of Offer Curve Analysis. This analysis explains how the terms of trade are determined by reciprocal demand Assumptions of this theory :- This theory is based on following assumptions (1) There is full employment situation. (2) There is perfect competition. (3) There are two countries & two commodities. (4) There is free trade between two countries (No restriction on imports & exports) (5) Factors of production are perfectly mobile within a country, (6) There is comparative cost advantage and specialisation. Meaning of Offer Curve :- Offer curve shows that - how much amount of one commodity, a country is ready to offer _for the given amount of another commodity. Thus, it indicates intensity of demand for foreign goods in a country. To derive offer curve, let us assume that : (1) Suppose, there are two countries-A & B, and two commodities - Cloth & Rubber. (2) Country-A specialises in the production of cloth. So, it exports cloth and imports rubber. (3) Country-B specialises in the production of rubber. So, it exports rubber and imports cloth. i= Now, to derive the offer curve of country-A, let us refer following schedule of trade propensity for country-A, Schedule of Trade Propensity for Country - A Cloth (exportable) | Rubber (importable) | Potential (Exchange Ratios) 25 5 40 10 60 20 80 40 100 100 THEORIES OF INTERNATIONAL TRADE 12NEERU CLASSES In the given example - (1) Initially, when country - A does not have any rubber to consume at all, it is willing to export 25 units of cloth in exchange for 5 units of rubber. This means that, at this stage, country - A is willing to trade with country - B, at 5 : 1 terms of trade. (2) Later on, country - A is willing to offer 40 units of cloth in exchange of 10 units of rubber. This means, now it is willing to trade with country - B at 4: 1 terms of trade. (3) Further, later on country - A willing to offer 60 units of cloth in exchange for 20 units of rubber (i.e. 3 units of cloth for 1 unit of rubber). (4) Later on, it is willing to pay smaller amount of cloth for every unit of imported rubber. This is because, as country - A goes on consuming more and more units of rubber, its marginal utility goes on diminishing. Hence, it is willing to pay lesser & less units of rubber for every additional unit of rubber. This is due to the law of diminishing marginal utility. Now, let us present above sets of offer on the diagram by points ~ A, B, C, D &E. if we join these points by a smooth curve, we will get the offer curve of country - A Ya 100 On 20 2 40 60 80 100 120° In this diagram, (a) X-axis measure rubber and Y-aeBhneasures cloth (b) A continuous line, which is drawn from point of origin connecting all these five points is the offer curve of country - A. It has a positive slope and it is non-linear. (c) At point - E, country - A is willing to offer 100 units of cloth in exchange for 100 units of rubber. Beyond this point, the offer curve has a negative slope. Beyond this point, trade will not take place. (d) Just like offer curve of country - A, we can also draw offer curve of country - B. the only point of difference is that country - A’s importable produce would be country B's exportable product and vice-versa. THEORIES OF INTERNATIONAL TRADE BNEERU CLASSES Just like the offer curve of country-A, we can derive the offer curve of country-B by the same logic. It is given in the following diagram. Yt Os 400 D In the given diagram, OB is 80 the offer curve of country-B. It is positively sloping. This curve shows $ that for the imports of given amount of 8 60 cloth, country-B is ready to export less a and less units of rubber. This is because 0 c of diminishing marginal utility of cloth. B 20} A . ° 20 40 60 80 100 120 X Rubber Equilibrium terms of trade :- Now, let us explain the determination of actual terms of trade with the help of following diagram. Ya Os je ait. Cloth ° by Rubber, (1) Ox and Os are the offer curves of country - A and country - B. (2) Both intersect each other at point - E. So, this is equilibrium point. At this point, country — A is willing to offer OT quantity of cloth in exchange for OR THEORIES OF INTERNATIONAL TRADE 14NEERU CLASSES quantity of rubber. Similarly, at this point, country - B is willing to offer OR quantity of rubber in exchange for OT quantity of cloth. This means, at this point, A’s demand for B’s product is exactly equal to B’s demand for A’s product (3) The straight line (0.) starting from the point of origin and going through point ~ Eis the equilibrium terms of trade line. (4) The two countries will expand trade along the terms of trade line (0.) upto point - E. But, beyond this point, they have U further. However, there is incentive to expand trade upto point - E. let us see why this is so. For example, if trade takes place at point - M, then at this point : = Country - A is ready to accept aye, amount of rubber in exchange of export of Qa, amount of cloth. But, country - B is ready to offer a,c, amount of rubber. Thus, country - B is ready to offer more quantity of rubber than whet is demanded by country - A. = Similarly, at this point, country - B is ready to accept a:c, amount of cloth in exchange of Ob1 amount of rubber. But, country - A is amount of cloth. Thus, for Ob; quantity of rubber, country - A is ready to offer more than what is demanded by country - B. Thus, at p. - (1) There is excess offer of cc) amount of rubber by country ~ B to country -A,& (2) There is excess offer of cscs amount of cloth by country — A to country - B This will encourage both the countries to expand their trade on the terms of trade line O. upto point — N. (at which the two offer curves intersect eachother). At this point the reciprocal demands of the two countries are exactly equal. So, this is equilibrium point. After this point, trade will not take place. Now, at equilibrium position, the size of international trade is => OT amount of cloth exports plus OR amount of rubber imports for country - A, which is exactly equal to = OT amount of cloth imports plus OR amount of rubber exports for country - B at O, terms of trade. (1) This theory is based on unrealistic assumptions such as perfect competition & full employment. (2) The assumption of free trade & factor mobility are not realistic. (3) This theory gives emphasis on only demand elasticity, but it ignores supply elasticity. According to Jacob Viner & other modern economist, terms of trade depends upon elasticity of demand for export & import as well as elasticity of supply of export & import. (4) Offer curve analysis explains the determination of terms of trade by reciprocal demand. But, it does not explain the factors, which are responsible for changes in the terms of trade. (5) This theory does not explain gains from trade. THEORIES OF INTERNATIONAL TRADE 5