© 9427950162 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 - II THEORY AND TERMS OF TRADE This study material covers: Heckscher - Ohlin Theories (Modern Theory of International Trade) |— La L Jp We can say that — Ais capital abundant country B is labour abundant country Suppose, there are two countries - A & B and there are two factors of production = labour (L) and capital (k). THEORY AND TERMS OF TRADE 2NEERU CLASSES a é Me ODE Po Po G P,P, Xx L (Labour) (1) In the given diagram, X-axis measures labour (L) and Y-axis measures capital (K). (2) The lines POPO show the factor price ratio in country - A and they are steeper. This shows that in this country, capital is cheaper and labour is costly. (3) Similarly, the lines P1P1 show the factor price ratios in country - B, and they are flatter. This shows that in this country, labour is cheaper and capital is expensive (4) Further aa and bb are the two iso-quants. They cut each other only once, at point Q. This indicates that there is no reversal of factor intensity. This means that, one commodity is capital-intensive in both the countries (K-good represented by the isoquant - aa) and the other commodity (L-good represented by the isoquant bb) is labour-intensive in both the countries. (5) Now, let us explain - how the capital abundant will export capital-intensive good, and labour-abundant country will export labour intensive good. Now, in country - A :- = The cost of producing one unit of K-good is HD amount of capital and HF amount of labour, because, at point - H, there is a tangency between the isocost line and isoquant curve (for K-good). = The cost of producing one unit of L-good is JE amount of capital (which is equal to HD) and F) amount of labour. = Now to produce one unit of L-good & K-good, country - A requires the same amount of capital (HD = JE) but to produce one unit of L-good, it requires more amount of labour (JE as against HF). = Thus, for this country, K-good is relatively cheaper. = So, it will specialize in the production and exports of capital intensive good (K- good). In coun: = The cost of producing one unit of L-good is MG amount of capital & MT amount of labour. THEORY AND TERMS OF TRADE 3NEERU CLASSES = The cost of producing one unit of K-good is RG amount of capital & NR amount of labour (which is equal to MT) = Thus, to produce K, country - 8 requires more amount of capital (RG against MG). = So, in this country L-good is relatively cheaper. = So, this country will specialize in the production and exports labour intensive good (L-good). Diagrammatic Presentation of Physical Criterion of Factor Abundance According to physical criteria country - A is capital-abundant and country - B is labour-abundant, if the following condition is fulfilled : Where KA and LA are the total amount of capital and labour, respectively, in country - A and KB and LB are the amount of capital and labour, respectively, in country - B. Here, country ~ A is capital abundant country, in terms of physical terms. So, it has a bias in favour of producing the capital intensive goods. Similarly, country ~ B,is labour abundant country. So, it has a bias in favour of labour intensive goods. Let us explain this with the help of following diagram : (1) AB is the production possibility curve of country - A and CD is PPC of country - B. (2) We assume that steel is the capital intensive good, and cloth is labour intensive good. (3) Now, suppose, both the countries (A & B) produce both the goods in the same proportion - along the line OR. So, country - A would produce at point = Q and country - B would produce at point - Q.. Cloth (4) In this case, the slope of country - A’s production possibility curve at point - Qu, is greater than country ~ B’s PPC at point - Q, (the factor price line P,P; is steeper than the factor price line P:P2). This shows that steel is cheaper in country = Aand cloth is cheaper in country - B. (5) So, country - A would specialize in the production of steel and country - B will specialize in the production of cloth. (6) So, country - A will export steel to country - 8, and will import cloth from country - B. Similarly, country - B will export cloth and will import steel from country - A. Conclusion Capital-abundant country specializes in the production and export of capital- intensive goods like steel and labour-abundant country specializes in the production and export of labour-intensive goods. THEORY AND TERMS OF TRADE 4NEERU CLASSES Now, which goods will be exported by a country, that depends upon the demand conditions (home consumption) of each country. Here, there are two possibilities, (1) If the consumption bias and the production bias are in the opposite direction (if consumption is less than production) - Country A will export steel & - Country B will export cloth. So in this case Hecksher Ohlin theory will be valid. (2) If the consumption bias and the production bias are in the same direction (if consumption is more than production) - Country A will import steel (instead pf exporting it.) & - Country B will import cloth (instead of exporting it). So in this case Hecksher Ohlin theory will not be valid. imitations /Criticisms :- HO theory is an improvement over the classical theory of international trade. But even then it has also certain limitations. Some of them are as follows - (1) Over simplified/unrealistic assumptions : This theory is based on certain unrealistic assumptions like those of classical theory. For example - assumptions regarding factor mobility, perfect competition, etc.) (2) One sided theory/Leon tiff paradox : This theory gives more importance to supply of factors in determination of factor prices & commodity. But, demand forces (condition) are also more important. For example - if demand for capital is greater than supply, price of capital will be higher, even in capital abundant country. In this case, even a capital abundant country will export labour intensive goods. This is the idea of “Leontiff paradox”. (3) Taste & Preference of Consumers : This theory assumes that the taste & preference of consumers are identical or same in both the countries, but this is not realistic. (4) Production Functions : This theory assumes that one good is labour intensive & th other is capital intensive in both the countries. But, in reality, it is possible that the same goods may be capital intensive in one country & labour intensive in the other country. This is the case of ‘factor reversal’. In this case, HO theory is not valid (5) Partial Equilibrium Analysis : This theory is only partial equilibrium analysis. This means, it has failed to develop comprehensive general equilibrium analysis. (6) Ignores Other Factors : According to this theory, difference in cost ratio & commodity prices arises due to difference in factor endowment. But, in reality, it may be due tomany other reasons, such as - = difference in factor qualities, = difference in technology, = difference in demand conditions, = increasing return to scale, etc. THEORY AND TERMS OF TRADE 5NEERU CLASSES (How H.O. Theory is an improvement over/refinement of/departure from the classical theory of international trade) production & i.e, labour. (2) According to this theory, trade arises due to difference in cost ratios of two countries. But, this theory does not explain - why there is difference in cost ratio. (3) This theory takes into account only supply conditions. But ignores demand conditions. (4) Classical theory assumes that labour is only factor of production. So, it measures cost in real terms (in terms of labour units) (5) This theory gives emphasis on gains from trade. (6) According to this theory, international trade is different from internal trade So, there is a need for separate theory of international trade. Classical Theory HO Theory (1) Classical theory of international trade | (1) HO theory is based on modern theory is based on labour theory of value,| of value (modern theory of which considers only one factor of production) which considers two factors of production labour & capital. (2) According to this theory, trade arises due to difference in commodity prices, which arises due difference in factor prices. Further, difference in factor prices arises due to difference in factor endowment. (3) This theory takes into account both demand conditions and — supply conditions. (4) HO theory measures cost in terms of factors prices i.e. in terms of money. (5) This theory explains structure of trade & factor price predictions. (6) According to this theory, international trade is not different from internal trade. This difference is of degree & not of kind. So, there is no need for separate theory of international trade. NEW TRADE THEORY OF KRUGMAN Q.1. Explain Krugman’s theory of nternational trade. OR Explain theory of economies of scale and imperfect competition. A.1 Introduction: The Traditional theories of international trade did not provide sufficient explanation about the rapid global development in 1980 and 1990. The traditional theories failed to provide the /ogical explanation about following aspects. * Why there was the accumulation of massive trade deficits of USA? + Why there was the rapid loss of global competitiveness of many US firms? As a result, these theories were criticized. In this regard, two new contributions were made. One by controversial economist Dr. Paul Krugman and the other by Harvard Professor Michael Porter Dr. Paul Krugman has focused his work on the following question. ‘Why and how trade is altered (changed), when the markets are not perfectly competitive?” THEORY AND TERMS OF TRADE 6NEERU CLASSES Therefore Krugman's theory is known as “Theory of Economies of Scale and On the other hand, Michael Porters theory is known as “Porter’s demand”. KRUGMAN’S CONTRIBUTIONS ON “ECONOMIES OF SCALE” & “IMPERFECT COMPETITION” Krugman's contribution of the new theory of trade mainly focuses on the relationship between cost, price & and international trade. Dr. Krugman has focused on two types of economies of scale namely internal economies of scale and external economies of scale. (1) Internal economies of scale: According to Krugman, if the cost per unit (average cost) of output depends upon the size of individual company, the average cost varies inversely with the size of the company. It means when the size of the company is larger, the company gets “Scale benefits” (the benefits of large scale operation). So, the cost per unit of output is also lower. This is known internal economies of scale. Due to internal economies, the company would produce more in order to lower the average costs. When average cost is lower, the company can sell its product at a lower price as to its competitors. As a result, the company can monopolize the industry both domestically as well as internationally. This will create imperfect market. This is because such company becomes the price maker. When company makes further expansion, then it can also take away the resources from the other domestic industries. So, the resources of the other industries would shrink (reduce). As a result, the other industries have to abandon (drop) certain range of products. Therefore, finally the country would specialize in the industry in which that monopolistic company operates. This is what exactly suggested by the HO model of the comparative advantage. When other industries abandon certain range of products, it will create an opportunity for ether countries (foreign countries) to specialize in such products, which are being, abandoned domestically. Therefore, internal economies (fall in cost and fall in price) create the imperfect competition and finally the opportunity of international trade. (2) External economies of scale: If the cost per unit (average cost) of output depends upon the size of an industry (not only on the size of the individual company), then industry of that nation can produce the products at lower costs than the industry of other nations. For example, * Malaysia has got /arger cluster (group) of small and medium size companies in Penang, which collectively produce very large quantities of semi- conductors. * On the other hand, Japan and South Korea have got very large companies, which produce massive quantities of semi-conductors. + Still, Malaysia dominates the world trade in semi conductors, THEORY AND TERMS OF TRADE 7NEERU CLASSES Large group of small and medium companies of Malaysia have created more external economies as compared to large companies of Japan and South Korea. Therefore, the external economies may not create the imperfect competition, but may & , course create an opportunity of international trade (i) Whenever there are economies of scale (whether internal or external), it would create the advantages in terms of lowering the cost and lowering the price. (ii) Such economies of scale would finally create the opportunity for a country to enter into international trade with other countries. (iii) The opportunity for international trade is created, irrespective of whether economies of scale would create the imperfect competition or not In this sense, this theory establishes the relationship between the cost, price and the international trade. TERMS OF TRADE ] (@) . Explain the different types of terms of trade. . Meaning :- Terms of trade refers to the rate, at which the goods of one country are exchanged against the goods of other countries. It depends upon export prices & import prices. We know that various countries in the world participate in trade in order to get benefits (gains) from it. But, the gain from trade to each country depends upon the terms of trade. So, the concept of terms of trade has received great attention in the area of international trade. Different economists have expressed different concepts of terms of trade. Following are the major concepts of terms of trade - = This concept was introduced by Taussig in 1927. = It is an improvement over Net Barter terms of trade. Gross Barter terms of trade are defined as the ratio of quantity index of imports (Mq) to quantity index of exports (Xq). Symbolically, it can be expressed as follow: Where, G = Gross Barter Terms of Trade Mq = Quantity index of imports, & Xq = Quantity index of exports. The ratio (Mq / Xq) is multiplied by 100 to avoid decimal. Let us explain this concept with the help of numerical example : Suppose, 2010 is the base year. So, the quantity index of both export and import will be 100. Now, let us refer the following numerical example : THEORY AND TERMS OF TRADE 8Q) NEERU CLASSES Year Ma = xa Value of 6 100 2010 © 100 100 ==-~ « 100 = 100 (base year) 100 120 2012120, 100 aan x 100 = 120 (improvement) 100 120 2012120 120 === « 100 = 100 (no change) 120 100 2013 100120. === « 300 = 83.3 (deterioration) 120 From the above example, it is clear that (1) In 2011, the quantity index of imports has increased from 100 to 120, and the quantity index of exports has remained the same. (This means, in 2011, against the same exports, we are able to import more goods). Thus, the purchasing power of our exports has increased by 20% in 2011 as compared to that in the base year (2010). So, there is improvement in the terms of trade. (2) In 2012, the terms of trade has remained constant. In 2013, the quantity index of exports has increased from 100 to 120, but the quantity index of imports has remained the same. (This shows that, to import the same goods, we have to export more goods). So, there has been deterioration in the terms of trade. In short (1) When there is an increase in quantity index of imports (Mq), there is an increase in the value of G. So, there is improvement in the terms of trade (2) When the changes in quantity index of exports and quantity index of imports are equal, G remains the same. So, there is no change in the terms of trade (3) When there is increase in quantity index of exports (Xq), there is fall in the value of G. So, there is deterioration in the terms of trade. In the above example, in 2011, there is an improvement, in 2012 there is no change and 2013; there is deterioration in the terms of trade. This concept has been used in classical and neo-classical analysis and also in the theory of reciprocal demand and offer curve analysis. Limitation of Gross Barter Terms of Trade :- (1) The gross barter terms of trade takes into account unilateral payments, which are not appropriate (because these payments are not affected whether there is any trade or not). So, it is not proper to include the loss or gain arising from unilateral payments as gain from trade. (2) This concept reflects less price movement that changes in the balance of payments, and even capital movements. So, many economists prefer to use net barter terms of trade rather than gross barter terms of trade. = The difference between net barter terms of trade and gross barter terms of trade is that the gross barter terms of trade uses quantity index for imports and exports. But, net barter terms of trade uses price index for exports and imports. = Net barter terms of trade (N) can be defined as the ratio of price index of exports (Xp) to price index of imports (Mp) Symbolically, it can be expressed as follow Where, N = Net Barter Terms of Trade Mp = Price index of imports, & Xp = Price index of exports. THEORY AND TERMS OF TRADE 9NEERU CLASSES Here, the ratio (Xp / Mp) is multiplied by 100 to avoid decimal. Let us explain this concept with the help of numerical example considering 2010 as the base year. Year Xp Mp Value of N 100 ---- « 100 = 100 (base year) 100 120 2011 120 100 ---~ x 100 = 120 (improvement) 2010 100 100 100 2012. 100 120 83.3 (deterioration) 120 = «100 = 100 (Constant or no change) 120 96 2013 120 120 2014 «96S 80 = x 100 = 120 (improvement) 80 126 2015 126 140 ---- 100 = 90 (deterioration) 140 From the above table, it is cleared that : (1) In 2011, there is an improvement in the terms of trade, because we got 20% higher price for our exports as compared in same in 2010. (2) In 2012, there is deterioration in the terms of trade, because we have to pay 20% higher price for our imports. This shows that, when there is an increase in our export price index (Xp), there is an improvement in commodity terms of trade. But, when there Is an increase in our import price index (Mp), there is deterioration in commodity terms of trade. In other words, when export price increases and import price decreases, there is improvement in terms of trade and vice-versa. (3) In 2013, there is an increase in both -export price index and the import price index by same percentage. So, there is no change in net barter terms of trade. (4) In 2014, there is decrease in both ~ the export price index and the import price index, but they have changed in such a way that commodity terms have become favourable. (5) In 2015, there is an increase in both export and import price index, but they have changed in such a way that commodity terms have become unfavourable. There is a general belief that an improvement in commodity terms of trade means an improvement in the economic welfare of the country. This is because, when export prices go up and import prices fall, it shows that we are able to sell out goods at higher price and buy foreign goods at lower price. So, there is a benefit to a country in terms of economic welfare. The concept of net barter terms of trade is widely accepted as a useful device for measuring short-term changes in the trading positions. Further, it indicates the purchasing power of our exports in paying for imports. Limitation of Net Barter Terms of Trade :- (1) It does not indicate changes in balance of payment position because; it ignores the quantity of exports and imports. (2) It does not take into account of changes in the quantity and productivity of exports and imports. (3) It ignores changes in composition of trade and unilateral payments. THEORY AND TERMS OF TRADE 10sl (3) Year 2010 2011 2012 (4) NEERU CLASSES Income Terms of Trade = The income terms of trade takes into account trade was first developed by GS Dorrance, in 1948-49, = The gross barter terms of trade takes into account the quantity index of exports and imports and the net barter terms of trade takes into account the price index of exports and imports. = But, Income terms of trade (I) is defined as net barter terms of trade multiplied by quantity index of exports. This can be expressed as follow : I N.Xq OR I Where, I Income Terms of Trade N Net Barter Terms of Trade & Xq = Quantity index of exports. This concept takes into account the changes in the volume of exports due to changes in the export prices. It indicates the capacity of a country to import out of its exports earnings. Let us refer following illustration, using 2010 as a base year- Export Price Import Price Export Index (Xp) Index (Mp) it Quantity Value of I Index (Xa) 100 « 100 100 100 100 waan==-= = 100 (base year) 90 100 120 = 108 (improvement) 110 100 80 = 88 (deterioration) From the above table : (1) In 2011, export price index has fallen by 10%, but export quantity index has increased by 20%. So, there has been improvement in terms of trade (2) In 2012, the export price index has increased by 10%, but the export quantity index has fallen by 20%. So, there has been deterioration in income terms of trade. It should be noted that (1) When T increases, there Is an improvement in the terms of trade. This means, the country obtains large volume of imports from its export earnings. (2) Similarly, when T falls, there is deterioration in the terms of trade, (3) However, it should be remembered that income terms of trade indicates only the export based capacity to import, and not the total capacity of the nation to import. The concept of income terms of trade is considered as superior to the concept of Net barter TOT or less developed countries. Single Factoral Terms of Trade :- = This concept was introduced by Jacob Winer. = This concept takes into account productivity factors of production in export sector. = Single factoral terms of trade is defined as the ratio of the export price index to the import price index, adjusted for changes the productivity of the factors used in export production. THEORY AND TERMS OF TRADE 1NEERU CLASSES Symbolically, it can be expressed as follow : Xp Xp x Xz S=N.Xz OR S= = x X25 - Mp Mp Where, S = Single Factoral Terms of Trade N= Net Barter Terms of Trade & Xz = Export Productivity index. Let us refer the following illustration considering 2010 as a base year - Export Price Import Price Export Year Index(Xp) Index (Mp) Quantity Value of S Index (Xz) 100 x 100 2010 100 100 100 = 100 (base year) 2011 80 100 100 = 90 (deterioration) 2012 90 100 120 = 108 (improvement) 2013 80 100 125 = 100 (no change) From the above table - (1) In 2011, the export price index has declined by 10%, but there is no change in the export productivity index. So, there has been deterioration in S (single factoral terms of trade). (2) In 2012, the export price index has declined by 10%, but the export productivity index has increased by 20%. So, there has been improvement in S. (3) In 2013, the fall in export price index has been compensated by rise in export productivity index. So, there has no change in S. It should be noted that :~ (1) An increase in S indicates an improvement and a decrease in S indicates deterioration in the terms of trade. (2) S will improve, even when Xp/Mp are constant. (This is due to increase in Xz). Some economists believe that, when there is improvement in the single factoral terms of trade, due to increase in export productivity index, it may give benefit to another country also. Particularly, when exporting country is rich and the importing country is poor, the gain of increase in productivity may be transferred to poor country. This may reduce global income inequalities and may increase welfare of poor country. However, some other economists do not agree with this. (1) It does not consider the domestic cost of production of imports. (2) It is also different to collect data, to calculate changes in the productivity of factors of production. (5) Double Factoral Terms of Trade :- = This concept was also introduced by Jacob Viner. = When the net barter terms of trade are corrected for changes in the productivity of factors in producing exports as well as imports, we will get double factoral terms of trade. This can be expressed as follow THEORY AND TERMS OF TRADE 12Where, D Xz Double Factoral Terms of Trade; N Export Productivity index; Mz It should be remembered that : (1) If D increases, there is an improvement in the terms of trade. (2) If D falls, there is deterioration in the terms of trade. NEERU CLASSES Net Barter Terms of Trade & Import Productivity index... Limitation :- It is very difficult to measure the productivity of both - exports and imports. So, both these concepts namely single and double factoral terms of trade has limited applicability. When Gross Barter TOT is equal to Net Barter TOT? Gross barter terms of trade is equal to net barter terms of trade, when there is equilibrium in balance of payment positions of a country. When there is equilibrium in balance of payment, Value of Imports = Value of Exports Mq . Mp = Xq. Xp Mq = Xp Xq Mp G=N Thus, when there is equilibrium in balance of payment, gross barter terms of trade is equal to net barter terms of trade. Q.2. Difference between Gross Barter Terms of trade, Net Barter Terms of Trade and Income Terms of Trade? A.2. Following are the main points of distinction between gross barter terms of trade, net barter terms of trade and income terms of trade. Gross barter TOT Net Barter TOT Income TOT (4) Gross barter terms of (1) Net barter terms of (4) Income terms of trade trade introduced by | trade introduced by Jacob | introduced by G.S.Dorrance Taussing. Viner. (2) G = MQ x 100 (2) N= Xp x 100 Xq Mp (3) It uses quantity index for imports and exports. (3) It uses price index for imports and exports. (3) It considers quantity index of export in addition to price index of both. (4)_When value of G increases, it shows that a country is able to buy more goods in exchange of its imports. (4) When value of W increases, it shows that a country ‘is getting more prices for exports as compared to prices of imports, (4) Whe3n value __of increases, It shows that a country is able to import large quantity of imports out of export income. (5) It does not consider prices of export. (5) It doers not consider quantity of export () If consider quantity of export as well as prices of exports (6) i is not used commonly. (6) it is most commonly used to measure of TOT. (6) It is considered superior concept as compared to Net barter TOT, for developing countries. THEORY AND TERMS OF TRADE 3NEERU CLASSES . Basically, the terms of trade of country depends upon the relative intensity of its import demand and export demand (as compared to that of the other countries). This means, the terms of trade depends upon following elasticities : (a) Elasticity of demand for imports of the country (Dm); (b) Elasticity of demand for its exports by the foreign country (Dx); (c) Elasticity of supply of its exports (Sx); and (d) Elasticity of supply of its imports i.e. exports of foreign country (Sm). These four kinds of elasticity are collectively known as the “reciprocal demand elasticity”. When there are changes in reciprocal demand elasticity, there are changes in terms of trade. Now, the reciprocal demand elasticity depends upon a number of factors. Some of them are as follow (1) Size of the population and population growth :- if the size of population of a country is large and if there rapid population growth, demand for imports will be more intensive. (2) Resourcefulness of the export supply :- This means no bottlenecks in supply. (3) Nature of goods (to be imported and exported) :- Generally, demand for primary products (agricultural products) is inelastic, but demand for the manufactured goods is elastic. (4) Diversification of products :- When a country is able to produce its bargaining position is stronger. Further, it can increase its export and reduce its imports. So, the terms of trade are favourable. (5) Tastes of people and capacity to buy :- The taste & preference of people determine the type of goods to be imported by a country and its economic development determine its capacity to buy (i.e. quantity of goods to be imported). (6) Level of national income and stage of economic development. When there is a change in any of the above factors, it brings a change in terms of trade. However, the main factors of trade affecting terms of trade are as follow (1) Shift in demand for imports or exports or both. (2) Tariffs (Govt. policy regarding tariffs). (3) Devaluation or Depreciation (4) Economic development. (5) Availability of substitutes. Let us explain these factors in detail - (1) Effects of shift in demand on the terms of trade :- At given terms of trade, the demand for and supply of imports and exports of the two countries are equal. Now, if there is increase in demand for the imports of a country, the prices of imports will rise (in relation to prices of exports). So, there is deterioration in the terms of trade. But, if there is increase in demand for exports of a country, the prices of its exports will rise (in relation to prices of imports). So, there is an improvement in the terms of trade, Let us explain this with the help of following diagrams : THEORY AND TERMS OF TRADE 14Cloth NEERU CLASSES Ys Diagram - IT . e op 08 e iy“on A ¢ g Q * - > ° Rubber 8 ° Rubber BB x = In both the diagrams, X-axis measures rubber and Y-axis measures cloth. In both the diagrams, OA is offer curve of country - A, which exports cloth and OB is offer curve of country - B, which exports rubber. = Now, in diagram - I suppose A’s demand for B's rubber increases, so the offer curve of country - A shifts from OA to OA’. So, now there is deterioration in the terms of trade for country ~ 8, which exports rubber. = Similarly, in diagram - T, suppose B’s demand for A’s cloth increases. So, the offer curve of country - B shifts from OB to OB’. So, now there is improvement in the terms of trade for country ~ A and deterioration of country - B. (2) Effects of Tariffs on terms of trade :- Y If @ country imposes tariffs on its imports (or places other restrictions on imports such as quota or exchange control), demand for imports will decline. So, there is improvement in the terms of trade. Let us explain this with the help of following diagrams : As shown in the diagram, (a) Suppose country - B imposes tariff (import duty) on import of cloth from country - A. as a result of import duty, B's offer curve shifts from OB to OB’ and the equilibrium terms of trade moves from point - N to point - N’. (b) Now, from given amount of rubber, country - B gets more units of cloth than earlier (before imposing tax) e.g before imposing tariff, OA of cloth was available against OB of rubber. But, ° B Yhow OA’ of cloth is available in Rubber exchange of OB of rubber. THEORY AND TERMS OF TRADE 15 Cloth(3) (4) (5) q@) NEERU CLASSES (c) Further, the equilibrium terms of trade moves from N to N’. This indicates that, for the same amount of cloth, country - B has to export less rubber. So, there is improvement in the terms of trade for importing country - B and deterioration for the opposite country. Devaluation :- Devaluation means an official reduction in the external value of our currency in term of foreign currency. Due to devaluation, our imports become costly and exports become cheaper. However, the actual effect of devaluation on the terms of trade depends upon the elasticity of demand for and supply of imports and exports of the country. (a) If elasticities of demand (for exports and imports) are greater than the supply elasticities, there is an improvement in the terms of trade. (b) If the demand elasticities are less than the supply elasticites, there is deterioration in the terms of trade. Economic Development (Economic Growth) :- The terms of trade of country depends upon the pattern of its economic development. As a result of economic development, the production possibility curve shifts upward. So, there is increase in output and income of a country. On one hand, increase in income results into increase in demand for imports. On the other hand, due to economic growth, there is increase in domestic production of import substitutes. This will reduce demand for imports. However, the net effect economic development on the TOT depends upon income elasticity of demand and supply. (a) When income elasticity of demand for imports is equal to one or greater than one (but elasticity of supply is less than one i.e. Edn, > Es,.) there is a net rise in demand for imports. So, there is deterioration in the terms of trade. (When elasticity of demand of imports > elasticity of supply of imports, imports will rise, So, there is deterioration in the TOT). (b) When income elasticity of demand for imports is less than one (but income elasticity of supply is greater), there is a net fall in demand for imports. So, there is an improvement in the TOT. Availability of substitution :~ If close substitutes for import goods are available in large quantity, the terms of trade will be favourable for the country. But, if substitutes are not available for import goods, the terms of trade will be unfavourable for a country. Conclusion :- Thus, the factors affecting terms of trade are the factors affecting demand and supply of exportable and importable goods. Further, these factors are influenced by the commercial policy of government (i.e. measures like tariff, quota, exchange control, devaluation, etc.). . Explain the significance of terms of trade. . As a theoretical concept and as a practical index, TOT is quite useful in economic theory and policy. Term of trade means the rate at which goods of one country are exchanged for goods of another country. Following are the main points indicating the significance of TOT. Gain from Trade :- The various countries participate in trade in order to get benefit (gain) from it. But, the size of gain from trade to each country depends upon the TOT. The TOT may be favourable or unfavourable to a country, depending upon the prices of exports and imports. If the TOT is favourable THEORY AND TERMS OF TRADE 16(2) (3) (4) (5) (6) NEERU CLASSES to a country, it will get 2 large share in the gain from trade. Thus, with the help of TOT, it is easy to understand who gains and who loses. (Without the help of TOT concept, it is not possible to find out the gain which arises from trade.) Construction of Offer Curve :- The concept of TOT is used for deriving offer curve. Offer curve is nothing but a locus of points of prospective terms of trade. Every point on offer curve shows the exchange ratio between the trading countries. Offer curve along with TOT is used for analysing various theoretical issues. Balance of Payment Position :- With the help of the concept of (gross barter) TOT, it is possible to understand the position of balance of trade and to formulate economic policy on trade. Imposition of Tariff :- In many cases, tariff is imposed after analvsing, the TOT and BOP situation of a country. If the terms of trade are unfavourable then tariff is imposed to improve it. Obviously, his depends upon the trade conditions and the nature of demand for tradable goods & services. Exchange Rate Policy :- The exchange rate policy (i.e. whether to follow fixed exchange rate or flexible exchange rate) is determined by government after considering the TOT & BOP position of a country. e.g. when the govt, adopts fixed or partially fixed exchange rate system, devaluation is done after considering TOT position: Welfare Effect :- The welfare of individual consumers and nation arising from trade depends upon the TOT. If the prices of imported goods are lower, then welfare of individual consumers will increase. On the other hand, if the TOT are unfavourable, it will reduce the welfare of consumers and nation. Thus, it is possible to measure gain or loss in welfare from the TOT. . Do favorable terms of trade always lead to economic development? Why? . It is believed that favourable terms of trade are very significant for the rapid economic development of less developed countries. When a country has favourable terms of trade, it can import a large quantity of goods against the given amount of exports. This increases the resources, of a country. So rapid growth becomes possible and national income rises. So, the favourabley terms of trade is a potential source of capital formation. However, favourable terms of trade can lead to economic development only if the additional resources thus made available are saved and invested in productive manner. If these resources are consumed away and not invested, there will be ne capital formation & on economic development. Further, the favourable effects of the improvement in the terms of trade may be_ offset by certain adverse circumstances as stated below, and rapid economic development may not take place. These adverse circumstances are as follow : (1) When the improvement in the terms of trade is achieved through restricted exports, resources may remain underutilised in export industries. Thus, the scope of employment, output and income may be limited. (2) If the improvement in the terms of trade is as a result of inflation, the adverse effect of inflation on the development process will supersede the favourable effect of terms of trade. (3) Further, when the terms of trade are improved by the price rise in exports due to 2 fall in the supply of exports, there is reduction in aggregate export. So relative import capacity may actually decline THEORY AND TERMS OF TRADE 17