LT 4. International Trade

Agribusiness Management: International Trade and Finance
AGRI-BUSINESS MARKETING
ABVM- M1041
INTERNATIONAL TRADE AND FINANCE (ABVM 1042)

(4 ECTS)
COMPLIED BY:
HUSSIEN MOHAMMED (MA, Economics)

BEKELU TESHOME (MSc. Applied and Agricultural Economics)
ASEFACH HAILU (M.Ed, Education)
Revised by:- Hiwot Mekonnen (MSc)
JULY 2012
3.2. LEARNING TASK II....................................................................................................3

Jimma, Haramaya, Hawassa, Ambo, Adama, Wolaita Sodo and Samara Universities
Page 1
3.2.1. INTRODUCTION 3
3.2.2. LEARNING TASK OBJECTIVE 4
3.2.3. SECTIONS 5
3.2.3.1. SECTION ONE: CONCEPTS OF INTERNATIONAL TRADE...................5
Definition of International Trade.................................................................................5
Inter -regional VS International Trade.........................................................................5
Difference between Inter-Regional and International Trade........................................5
Reasons for international trade and its significance.....................................................7
3.2.3.2. SECTION TWO: CLASSICAL AND NEO-CLASSICAL THEORIES OF
INTERNATIONAL TRADE.............................................................................................8
The Mercantilists Trade Theory..................................................................................8
Theories of Absolute and Comparative Advantage.....................................................8
Comparative Advantage and Opportunity Costs........................................................16
Heckscher-Ohlin Theory of Trade.............................................................................22
3.2.3.3. SECTION THREE: INTERNATIONAL PATTERNS OF TRADE AND
SPECIALIZATIONS......................................................................................................28
Changes in the global economy.................................................................................28
Sources of change in the patterns of global trade......................................................30
Specialization and international trade........................................................................31
3.2.3.4. SECTION FOUR: THEORY OF TRADE PROTECTION..........................32
Concepts and arguments of Protectionism.................................................................32
Means of Trade Restriction.......................................................................................35
3.2.3.5. SECTION FIVE: ECONOMIC INTEGRATION.........................................37
Types of regional trading arrangements....................................................................37
Effects of a regional trading Arrangement.................................................................39
3.2.3.6. SECTION SIX: BALANCE OF PAYMENT, DIS-EQUILIBRIUM AND
ADJUSTMENT...............................................................................................................42
Balance of payments accounting and accounts..........................................................42
Balance of Payments Surplus or Deficit....................................................................44
3.2.3.7. SECTION SEVEN: FOREIGN EXCHANGE MARKET.............................45
The Concept of Exchange Rate:................................................................................45
Nominal and Real Exchange Rates............................................................................48
Determinates of Exchange Rate in the Long-Run......................................................49
Exchange Control......................................................................................................49
3.2.4. Proof of ability 52
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3.2. LEARNING TASK II
3.2.1. INTRODUCTION
This material is prepared for the learning task “International Trade and finance”. The learning
task is a four ECTS which is divided into sections and sub sections. Each section begins with
an introduction, which briefly explains the subject matter of the section and also it gives the
structural map of the content. Following introductions under each sections and sub sections,
there are lists of objectives which are stated in terms of students’ achievement. These
objectives indicate what students are expected to acquire after completing each sections and
sub sections.
The learning task contains seven sections which deal with the basic concepts and theories of
international trade and finance. Each sections and sub sections will help you to understand
international trade and finance, the base for and gain from trade and commercial policies that
promote and restrict trade; the effect of international trade on economic growth, economic
integration and the effect of discriminatory commercial policies on international trade, foreign
exchange market and the balance of payment.
In the preparation of this material, all possible efforts have been made to enhance the
usefulness of the material. For convenient study of this course, there are pre-test and learning
activities at a reasonable interval of the sections. Practical aspects of the learning task are
considered to help the students and the instructor. Students will be assessed on continuous
basis as appropriate.
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3.2.2. LEARNING TASK OBJECTIVE
The main objective of the learning task is to help students understand, analyze and interpret
the pattern and trends of trade relationships among countries.
At the end of this learning task, students will be able to:
 explore the subject matter of international trade;

 explain the reasons, basis and gains of international trade;
 explain the historical development of international trade;
 explain classical and modern theories of international trade;
 explain the reasons for trade restriction between countries;
 explain economic integration and their effect on international trade;
 describe international patterns of trade and specializations;
 explain foreign exchange rate and how it is determined;
 explain the concept of balance of payment and disequilibrium
3.2.3. SECTIONS
3.2.3.1. SECTION ONE: CONCEPTS OF INTERNATIONAL TRADE
Ethiopia exports different goods and services especially agricultural commodities and import
capital goods for industrialization endeavor. The trade partners with Ethiopia are countries
from Asia, Africa, South and North America, and Europe. What do you know about
international trade and its importance for nations?
Definition of International Trade
Trade is the exchange of goods and services among individuals. Therefore:
 International trade is a business transaction between citizens of different nations and

with considerations of commercial diplomacy which usually springs from it.
Inter -regional VS International Trade
Inter-regional trade refers to the exchange of goods and services between regions within a
country. International trade, on the other hand, is trade between two or more countries.
Difference between Inter-Regional and International Trade
Different currencies: The principal differences between inter-regional and international trade
lies in use of different currencies in foreign trade, but the same currency in domestic trade.
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Problem of Balance of Payments: The problem of balance of payments is perpetual in

internationa1 trade while regions within a country have no such problem. This is because
there is greater mobility of capital within regions than between countries.
Factor Immobility: factors of production are freely mobile within a country but not across
countries.
Differences in Natural Resources: Different countries are endowed with different types of
natural resources. Hence they tend to specialize in production of those commodities in which
they are richly endowed and trade them with others where such resources are scarce. Those
countries can trade each other's commodities on the bases of comparative cost differences in
the production of different commodities.
Geographical and Climatic Differences: Every country can’t produce all the commodities
due to geographical and climatic conditions, except at possibly prohibitive costs.
Different Markets: International markets are separated by difference in languages, usages,
habits, tastes, fashions etc. Even the systems of weights and measures and pattern and styles
in machinery and equipment differ from country to country.
Mobility of Goods: The mobility of goods within a country is restricted by only geographical
distances and transportation costs. But there are many tariff and non tariff barrier on
movement of goods among countries.
Different Transport Costs: although both inter-regional and international trade involves
transportation cost, usually, the cost is higher for international trade due to the distance
involved. But this is not the case always.
Different Economic Environment: Countries differ in their economic environment which
affects their trade relations. The legal framework, institutional set-up, monetary, fiscal and
commercial policies, factor endowments, production techniques, nature of products, etc. differ
among countries.
Different National Policies: Another difference between inter-regional and international
trade arises from the fact that policies relating to commerce, trade, taxation, etc. are the same
within a country but differ from one country to another.
Similarities between Inter-Regional and International Trade
Classical economists underline the need for a different model to understand the functioning of
international trade. Bertil Ohlin, a Swedish economist, on the other hand, does not agree with
the classical argument of international trade. He considers international trade as a special case
of inter-regional trade. He supports his argument by stating the existence of barriers to labor
and capital mobility within regions and the free movement of capital and labor across
countries. The rapid development of the USA, Australia, New Zealand, Canada and the Latin
American Countries in the 19th and early 20th centuries has been due to the movement of
labor and capital from England and Europe. Same holds true for most of the above points: for
example, there are geographic and climatic differences, different markets, and differences in
resource endowment within countries as well. Therefore, Ohlin disagrees with the need for a
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separate model for international trade.
In addition, in both international and inter- regional trade:

 Factor is important and goods move from places of abundant supplies to places where
they are scarce;
 Transport costs are involved to move factors and goods from places to places;
 Trade is carried on by firms for the purpose of maximizing profits;
 Prices of traded goods are determined in the same way, which is based on the general
equilibrium of demand and supply.
Even though Ohlin’s arguments are correct, there are some sharp differences between inter-
regional and international trade which triggers the need to model and understand international
trade as a separate discipline.
Commonly used terminologies in international trade
 Protectionism is a movement in the direction of autarky due to a new trade policy which
further restricts the free flow of goods and services between countries.
 Trade liberalization is the elimination of trade policies and a movement in the direction
of free trade in order to increase the amount of international trade.
 Autarky is condition in which no international trade occurs and it represents a state of
isolationism.
 Laissez faire is principle of regulation of industry: the principle that the economy works
best if private industry is not regulated and markets are free.
 Free trade is pursuance of a "laissez faire" policy by government with respect to trade
and thus impose no regulation whatsoever that would impede (or encourage) the free
voluntary exchange of goods between nations
Reasons for international trade and its significance
In general, the immediate cause for trade among nations is difference in the prices of goods
and services among nations. Nations differ in resource endowments, the level of technology
and technical skills or know how. Moreover, nature has distributed resources unevenly in the
world which makes production of some goods in some countries impossible. Thus,
international trade has enabled the world to be able consume the goods they cannot produce.
Continuous Assessment
 Test 1 (5 points)
Summary
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A controversy has been going on among economists whether there is any difference between
inter-regional or domestic trade and international trade. The Classical economists asserted that
international trade was fundamentally different from domestic or inter-regional trade. Hence,
they evolved a separate theory for international trade based on the principle of comparative
cost differences.
The reasons for the need of international trade are difference in the prices of a commodity,
resource endowments, the level of technology and technical skills or know how among
nations. The major significance of international trade for nations is explained in terms of
providing expanded market; gain from specialization and division of labor; harmonization of
cultural exchange and diplomatic relation.
3.2.3.2. SECTION TWO: CLASSICAL AND NEO-CLASSICAL

THEORIES OF INTERNATIONAL TRADE
Nations involve in international trade through exporting and importing goods and services.
What do you think the basis for and gain from international trade among nations?
The Mercantilists Trade Theory
Mercantilism is economic nationalism which was advocated in the 16th century for the
purpose of building a wealthy and powerful state. Adam Smith in his book “The Wealth of
Nations” coined the term "mercantile system" to describe the system of political economy
that sought to enrich the country by restraining imports and encouraging exports. In other
words, the mercantilists maintained that the way for a nation to become rich and powerful was
to export more than it imported.
In any event, mercantilists advocated strict government control of all economic activities and
preached economic nationalism because they believed that a nation could gain in trade only at
the expense of other nations.
Adam Smith led an eloquent and vigorous attack upon mercantilist theories of international
trade in his book “Wealth of Nations” published in 1776. Smith argued that it was absurd to
manufacture a commodity in a country at a great expense if a similar commodity could be
supplied from foreign countries at a lower cost. He, thus, opposed the imposition of tariffs on
the goods imported from other countries, and recommended that trade among different
countries should be free and be based on 'territorial division of labor'. He advocated, the
doctrines of laissez-faire, or free markets, interpreted as economic welfare in a far wider sense
of encompassing the entire population.
Theories of Absolute and Comparative Advantage
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Theory of Absolute Advantage
Adam smith (1723-1790) provided the basic building blocks for the construction of the
classical theory of international trade. He enunciated the theory in terms of what is called
Absolute Advantage model. Adam Smith viewed that for two nations to trade with each other
voluntarily, both nations must gain. If one nation gained nothing or lost, it would simply
refuse to trade.
According to Adam Smith, trade between two nations is based on absolute advantage. When
one nation is more efficient than (or has an absolute advantage over) another in the production
of one commodity but is less efficient than (or has an absolute disadvantage with respect to)
the other nation in producing a second commodity, then both nations through trade can gain
by each specializing in the production of the commodity of its absolute advantage and
exchanging part of its output with the other nation for the commodity of its absolute
disadvantage.
Assumptions of the theory of absolute advantage
a) Labor is the only factor of production and is homogenous,

b) Labor was completely free to move within a single country, yet it was entirely
immobile internationally. If labor were free to move between nations, then differences in
wage rates and hence commodity prices could be equalized via labor migration, and
there would be no need for international trade,
c) Both countries can produce both commodities,
d) No transportation costs were involved in trade
e) There existed no other barriers, such as tariffs and quotas, to trade between
countries.
f) Constant returns to scale,
Illustration of absolute advantage
Imagine a hypothetical world composed of only two countries, country A and country B. Both
countries produce significant quantities of wheat and oil for domestic consumption, and there
are absolutely no trade relations, factor movements, or other economic ties between them; i.e.,
each is taken to be operating in a state of isolation (autarky). Assume for the moment also that
the entire value of the two commodities is the amount of labor used in their production. Now
suppose, further, that one man-hour of labor can produce the following quantities of wheat
and oil in the two respective countries:
Table 2.1: Absolute advantage
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Output of one Man-hour

Commodity Country A Country B
Wheat (Quintals) 5 10
Oil (barrels) 10 5
Table 2.1 and Figure 2.1 reveals that country A could produce 10 barrel of oil and no wheat, 5
quintal of wheat and no oil, or some combination of wheat and oil between these two
extremes with one man hour of labor. The different combinations that country A could
produce are represented by the line GG’ in the Figure 2.1 below. This is referred to as country
A’s production possibility frontier.
Fig 2.1 the Theory of Absolute Advantage
Similarly, country B could produce 5 barrel of oil and no wheat, 10 quintal of wheat and no
oil, or some combinations. The different combinations of wheat and oil available to country B
represented by the line KK’ in the figure, which is country B’s production possibility frontier.
In this case, a quintal of wheat in country A has twice the value of a barrel of oil and a barrel
of oil in country B has twice the value of a quintal of wheat. Apparently, country A has an
absolute advantage in the production of oil (10 barrel is greater than 5 barrel), and country B
has an absolute advantage in the production of wheat (10 quintal is greater than 5 quintal).
To see the benefit from an international trade, it is better to begin from autarky. As table 2.2
shows the combination of both goods produced and consumed by each country before trade.
Table 2.2: Pre trade production and consumption
Commodity Country A Country B World
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Wheat (Quintals) 5 10 15
Oil (barrels) 10 5 15
When both countries produce wheat and oil for domestic consumption, and absolutely no
trade relations exist between two countries, the world production would be 15 quintals of
wheat and 15 barrels of oil.
If the two countries opened their economy, the direction that trade would take can be
immediately determined. Therefore, country A would export oil to country B, in return for
which country B would export wheat to country A. In this case there is a scope for complete
specialization in production in both countries. The effect of opening trade between the two
countries is shown in the following table.
The table below reveals that before trade both countries produce only 15 units each of the two
commodities by applying one labor-unit on each commodity. If A were to specialize in
producing in oil production and use both units of labor on it, its total production will be 20
units of oil. Similarly, if B were to specialize in the production of wheat alone, its total
production will be 20 units of wheat. The combined gain to both countries from trade will be
5 units of oil and 5 unit of wheat for country A and B, respectively.
Table 2.2: production after specialization and gain from trade
Production Production
Gain from trade
before trade After trade
Commodity
Country Country Country Country Country Country
A B A B A B
Wheat (Quintals) 5 10 - 20 -5 +10
Oil (barrels) 10 5 20 - +10 -5
As a result of trade, the total production of the two countries went up. This means that both
countries become richer or have become better off in terms of production, after trade as
compared to before trade, without making any country worse off.
Criticism on theory of absolute advantage
Smith has been criticized for his vagueness and lack of clarity. Accordingly, Smith assumes
without argument that international trade requires an exporting country to have superiority
with a given amount of capital and labor to produce a larger output than any rival. But this
basis of trade is not realistic because there are many underdeveloped countries which do not
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possess absolute advantage in the production of any commodity, and yet they have trade
relations with other countries. Thus, Smith's analysis is weak and unrealistic.
Theory of Comparative Advantage
Like Adam Smith, David Ricardo emphasized the supply side of the market. The immediate
basis for trade stemmed from cost differences between nations, which were underlined by
their natural and acquired advantages. Unlike Adam Smith, who emphasized the importance
of absolute cost differences among nations, David Ricardo emphasized comparative cost
differences.
Comparative Advantage is a situation in which one country specializes in producing the goods
it produces most efficiently and buys the products it produces less efficiently from other
countries, even if it could produce the goods more efficiently itself.
Assumptions of the theory of comparative advantage
 The world consists of two nations, each using a single input to produce two
commodities.
 In each nation, labor is the only input. Each nation has a fixed endowment of labor,
which is fully employed and homogeneous.
 Labor is completely free to move within a single country among industries, yet is
entirely immobile internationally.
 Nations may use different technologies, but all firms within each nation utilize a
common production method or technology for each commodity.
 Costs do not vary with in the level of production and are proportional to the amount of
labor used.
 There are similar test between countries.
 Perfect competition prevails in all markets. Because it assumes that no single producer
or consumer is large enough to influence the market, all are price takers. Product
quality does not vary among nations, implying that all units of each product are
identical. There is free entry to and exit from an industry, and the price of each
product equals the products of marginal costs of production.
 Free trade occurs between nations (i.e.; no government barriers to trade exist).
 Transaction costs are zero. Consumers will thus be indifferent between domestically
produced and imported versions of a product if the domestic prices of the two products
are identical.
 Firms make production decisions in an attempt to maximize profits, where as
consumers maximize satisfaction through their consumption decisions.
 Trade is balanced; exports must pay for imports, thus ruling out flows of money
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between nations.
Illustration of comparative advantage
In his example Ricardo imagined two countries, England and Portugal, producing two goods,
cloth and wine, using labor as the sole input in production. Instead of assuming, as Adam
Smith did, that England is more productive in producing one good and Portugal is more
productive in the other; Ricardo assumed that Portugal was more productive in both goods.
Based on Smith's intuition, then, it would seem that trade could not be advantageous, at least
for England.
Ricardo showed that the specialization good in each country should be that good in which the
country had a comparative advantage in production. In order to identify a country's
comparative advantage, it requires a comparison of production costs across countries.
However, one does not compare the monetary costs or even the resource costs (labor needed
per unit of output) of production. Instead one must compare the opportunity costs of
producing goods across countries. This is illustrated in terms of Ricardo’s well known
example of trade between England and Portugal as shown in Table 2.3.
Table 2.3: Ricardo’s comparative cost
Country Wine Cloth

England 120 100
Portugal 80 90
The table shows that the production of a unit of wine in England requires 120 men for a year
while a unit of cloth requires 100 men for the same period. On the other hand, the production
of the same quantities of wine and cloth in Portugal requires 80 and 90 men respectively.
Thus, England uses more labor than Portugal in producing both wine and cloth. In other
words, the Portuguese labor is more efficient than the English labor in producing both the
products. So Portugal possesses an absolute advantage in both wine and cloth. However,
Portugal would benefit more by producing wine and exporting it to England because it
possesses greater comparative advantage in it. This is because the cost of production of wine
(80/120 men) is less than the cost of production of cloth (90/100 men).
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Fig 2.2 Theory of Comparative Advantage
On the other hand, it is in England’s interest to specialize in the production of cloth in which
it has the least comparative disadvantage. This is because the cost of cloth production in
England in less (100/90 men) as compared with wine (120/80 men). Thus, trade is beneficial
for both the countries. The comparative advantage position of both is illustrated in Fig. 2.2 in
terms of production possibility curves.
PL is the production possibility curve of Portugal, and EG that of England. Portugal enjoys an
absolute advantage in the production of both wine and cloth over England. It produces OL of
wine and OP of cloth, as against OG of wine and OE of cloth produced by England. But the
slope of ER (parallel to PL) reveals that Portugal has a greater comparative advantage in the
production of wine because if it gives up the resources required to produce OE of cloth, it can
produce OR of wine which is greater than OG of wine of England. On the other hand,
England had the least comparative disadvantage in the production of OE of cloth. Thus,
Portugal will export OR of wine to England in exchange for OE of cloth from her.
Gains from Trade and Their Distribution
The opportunity for gain can be seen immediately by comparing the real exchange ratios that
will prevail in each country in the absence of international trade. In Portugal, in isolation 1
unit of cloth will exchange for 1.13 barrels of wine
Table 2.4: Exchange rate before trade
England Portugal
Wine 120 : 100 Cloth (1 : 1.2) Wine 80 : 90 Cloth (1 : 0.89)
Cloth 100 : 120 Wine (1 : 0.83) Cloth 90 : 80 Wine (1 : 1.13)
Suppose now, as Ricardo did, that both countries are offered the chance to trade at the barter
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exchange ratio 1 cloth for 1 wine. Portugal will find such trade an attractive way to acquire
cloth. Instead of giving up 1.13 barrels of wine to obtain 1 cloth, it need give up only 1 barrel
of wine. It saves 0.13 barrel of wine on each unit of cloth acquired.
Consequently, Portugal will specialize in wine production, and obtain its cloth from England
through trade. Similarly, England will benefit because for one cloth it can obtain a barrel of
wine, instead of only 0.89 of a barrel as in direct production. It will specialize in cloth,
obtaining wine from Portugal through trade at less cost than it can be produced at home. Thus
Ricardo showed that both countries gain, even though Portugal enjoys an absolute advantage
in both commodities.
The gains from trade and their distribution are also shown in Figure 2.3 where the line C1W2
depicts the domestic exchange ratio 1 unit of cloth = 0.83 unit of wine of England, and the
line WI C2 that of Portugal at the domestic exchange ratio 1 unit of wine = 0.89 unit of cloth.
The line C1 W1 shows the exchange rate of trade of 1 unit of cloth = 1 unit of wine between
the two countries. At this exchange rate, England gains W2W1 (0.17 unit) of wine, while
Portugal gains C2C1 (0.11 unit) of cloth.
Fig 2.3. Theory of comparative advantage
At this point, you may ask, “How did Ricardo know that the barter terms of trade between
Portugal and England would be 1C: 1W?” The answer is that he did not know precisely what
that rate would be. All he knew was that the international exchange ratio had to lie somewhere
in between the two domestic ratios, that is,
Portugal 1C : 1.13W
England 1C : 0.83W
Any ratio between these two limits will permit both countries to gain from trade. Ricardo
chose the ratio 1C: 1W because it was a convenient one to use in making his point. He did not
discuss the forces that would determine the exact ratio that would exist in the market. He
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simply said that the two countries would gain from trade so long as England concentrated on
the production of cloth and Portugal on the production of wine. Ricardo did not give a name
to the principle, but it has long been known as the law of comparative costs.
Criticisms on the comparative cost advantage theory
 The most severe criticism of the comparative advantage doctrine is that it is based on the
labor theory of value. Under the labor theory of value, the value or price of a commodity
depends exclusively on the amount of labor time going into the production of the
commodity. Since neither of these assumptions is true, the labor theory of value must be
rejected.
 Labor is also not used in the same fixed proportion in the production of all commodities.
 Ricardo ignores transport costs in determining comparative advantage in trade. This is
highly unrealistic because transport costs play an important role in determining the pattern
of world trade.
 The assumption that factors of production are perfectly mobile internally and wholly
immobile internationally. This is not realistic because even within a country factors do not
move freely from one industry to another or from one region to another.
 The Ricardian model is related to trade between two countries on the basis of two
commodities.
 Another serious weakness of the doctrine is that it assumes perfect and free world trade.
But, in reality, world trade is not free.
 The theory of comparative advantage is based on the assumption of full employment. This
assumption also makes the theory static and unrealistic.
 The theory neglects the role of technological innovations in international trade.
 The Ricardian theory is one-sided because it considers only the supply side of
international trade and neglects the demand side.
 Complete specialization will be impossible on the basis of comparative advantage in
producing commodities entering into international trade.
 The classical conclusion of complete specialization between two countries can hold
ground only by assuming trade between two countries of approximately equal economic
performance.
 The theory simply explains how two countries gain from international trade. But it fails to
show how the gains, from trade are distributed between countries.
Comparative Advantage and Opportunity Costs

Opportunity Costs and The production possibility curve
According to the opportunity cost theory, the cost of a commodity is the amount of a second
commodity that must be given up to release just enough resources to produce one additional
unit of the first commodity. Consequently, the nation with the lower opportunity cost in the
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production of a commodity has a comparative advantage in that commodity (and a compar-

ative disadvantage in the second commodity).
For example, based on Table 2.4, if in the absence of trade the Portugal must give up 0.89 unit
of cloth to release just enough resources to produce one additional unit of wine domestically,
then the opportunity cost of wine is 0.89 unit of cloth (i.e., 1W = 0.89C in Portugal). If lW =
1.2C in England, then the opportunity cost of wine (in terms of the amount of cloth that must
be given up) is lower in the Portugal than in England. Therefore, it can be said that Portugal
would have a comparative (cost) advantage over England in wine production. In a two-nation,
two commodity world, England would then have a comparative advantage in cloth.
Incomplete Specialization
There is one basic difference between trade model under increasing and the constant
opportunity costs case. Under constant costs, both nations specialize completely in production
of the commodity of their comparative advantage. However, under increasing opportunity
costs, there is incomplete specialization in production in both nations.
The reason for this is that as country I specializes in the production of X, it incurs increasing
opportunity costs in producing X. Similarly, as country II produces more Y, it incurs
increasing opportunity costs in Y (which means declining opportunity costs of X). Thus, as
each nation specializes in production of the commodity of its comparative advantage, relative
commodity prices move toward each other until they are identical in both nations. This occurs
before either nation has completely specialized in production.
The Gains from Exchange and Specialization
A country’s gains from trade can be broken down into two components: the gains from
exchange and the gains from specialization.
Suppose that, for whatever reason, country I could not specialize in the production of X with
the opening of trade but continued to produce at point A. Starting from point A, country I
could export 20X in exchange for 20Y at the prevailing world relative price of Pw = 1, and
end up consuming at point T on indifference curve II. Even though country I consumes less of
X and more of Y at point T in relation to point A, it is better off than it was in autarky because
T is on higher indifference curve II. The movement from point A to point T in consumption
measures the gains from exchange.
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Figure 2.4 Gains from Exchange and Specialization
If subsequently country I also specialized in the production of X and produced at point B, it

could then exchange 60X for 60Y with the rest of the world and consume at point E on
indifference curve III. The movement from T, to E in consumption measures the gains from
specialization in production.
Note that country I is not in equilibrium in production at point A with trade because PA<Pw.
To be in equilibrium, country I should expand its production of X until it reaches point B,
where PB = Pw= 1. Country II's gains from trade can similarly be broken down into gains from
exchange and gains from specialization.
Offer Curve and Terms of Trade
The Offer Curves of a Nation
Offer curves incorporate elements of both demand and supply, we shall see how, international
terms of trade are established by the interaction of supply and demand. Alternatively, we can
say that the offer curve of a nation shows the willingness of the nation to import and export at
various relative commodity prices. The offer curve of a nation can be derived rather easily
and somewhat informally from the nation's production frontier, its indifference map, and the
various hypothetical relative commodity prices at which trade could take place.
Derivation of Offer Curve
The terms of trade or offer curve of the countries, are determined by the intensity of domestic
demand for foreign goods and of the foreign demand for domestic goods.
Figure 2.5 (a) shows a production possibility curve and a set of community indifference
curves that characterize demand in country I. In the absence of trade, equilibrium will be
established at point A, where an indifference curve is tangential to the production possibility
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curve. At this point, the marginal rate of substitution in production equals the marginal rate of
substitution in consumption. The highest level of satisfaction that the country can enjoy under
autarky is that symbolized by the indifference curve I. The price ratio that will be ruling under
autarky is given by the line P=¼, which is tangential to the production-possibility curve and
the indifference curve at A.
Suppose now that we open up the, possibility of international trade. Production and demand
conditions in country I, are as shown in Figure 2.5(a). Which commodity country I will export
and import depends on the international terms of trade that are established. Let country I has a
comparative advantage in production of commodity X and that the new terms of trade
established under trade are as shown by the line P = ½ in Figure 2.5 (a). country I will then
produce at point F and consume at point H, and export FG (40X) of commodity X in
exchange for GH (20Y) imports of commodity Y.
By trade, country I can move to the indifference curve II, which represents a higher level of
satisfaction than do I. Had the terms of trade been even more favorable, for instance such as
represented by P=1, the country could have reached indifference curve III by trading BC
(60X) of X for CE (60Y) of Y.
We can now show how country I's volume of exports and imports change as the terms of trade
change. As it has been shown in Figure 2.5 (b), on the vertical axis, we have net exports of Y
and on the horizontal axis we have net imports of X. The triangle 0GH in Figure (b)
corresponds to the trade triangle HGF in Figure 2.5 (b). It shows that if the terms of trade are
0H (these terms of trade are the same as those depicted by P F = ½ in Figure 2.5 (a)),"40X will
be exchanged for 20Y. If the terms of trade instead should change to 0E (which corresponds
to PB = 1 in Figure 2.5 (a)), 60X would be exchanged for 60Y (the triangle 0CE corresponds
to the trade triangle BCE in Figure 2.5 (a).
Figure 2.5 Offer curve for country I

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In this way we can trace out a pattern of points that show how the traded volumes change
when the terms of trade change. If we join together all these points for country I, we get a
curve such as 0K in Figure 2.5(b). 0K is an example of an offer curve. Thus an offer curve
shows how the volumes traded change when the terms of trade change.
The offer curve of the trade partner is derived in a completely analogous way, that is, from its
production frontier, its indifference map, and the various relative commodity prices at which
trade could take place.
Figure 2.6 Offer curve for country II
Figure 2.6 (a) indicates that, country II starts at the autarky equilibrium point A’. when trade
takes place at PH’ =Px/Py= 2 , country II moves to point F' in production, exchanges 40Y for
20X with country I, and reaches point H' on its indifference curve II'. Trade triangle F'G'H' in
the Figure 2.6 (a) corresponds to trade triangle O'G'H' in the Figure 2.6 (b), and we get point
H' on country II’s offer curve.
At PE’’ = Px/Py = 1 in Figure 2.6 (a), country II would move instead to point F' in production,
exchange 60Y for 60X with country I, and reach point E' on its indifference curve III'. Trade
triangle B'C'E' in Figure 2.6 (a) corresponds to trade triangle 0'C'E' in Figure 2.13 (b) and we
get point E' on country II’s offer curve.
Joining the origin with points H' and E' and other points similarly obtained, we generate
country II’s offer curve in the right panel. The offer curve of country II’s also shows how
much imports of commodity X country II demands to be willing to export various quantities
of commodity Y.
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The Equilibrium Relative Commodity Price with Trade
The offer curves of the two trading countries intersect at point E. This is the only equilibrium
point and the equilibrium terms of trade are given by the ray 0E from the origin. Only at this
equilibrium price will trade be balanced between the two nations. At any other relative
commodity price, the desired quantities of imports and exports of the two commodities would
not be equal. This would put pressure on the relative commodity price to move toward its
equilibrium level.
The offer curves of country I and II in Figure 2.7 intersect at point E, defining equilibrium
relative price (PB =PB’,= 1). At PB, country I offers 60X for 60Y and country II offers exactly
60Y for 60X. Thus trade is in equilibrium at PB.
Figure 2.7 Equilibrium Relative Commodity Price with Trade
At any other price, trade would not be in equilibrium. For example, at P F = ½, the 40X that
country I would export would fall short of the imports of commodity X demanded by country
II. In this case, the excess import demand for commodity X by country II tends to drive Px/Py
up. As this occurs, country I will supply more of commodity X for export (i.e., country I will
move up its offer curve), while country II will reduce its import demand for commodity X
(i.e., country II will move down its offer curve). This will continue until supply and demand
become equal at PB.
Change In Terms Of Trade
The terms of trade of a nation are defined as the ratio of the price of its export commodity to
the price of its import commodity. Since in a two nation world, the exports of a nation are the
imports of its trade partner, the terms of trade of the 'latter are equal to the inverse, or
reciprocal, of the terms of trade of the former.
These terms of trade are often referred to as the commodity or net barter terms of trade. As
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supply and demand considerations change over time as a result of factors affecting demand
and supply of tradable, offer curves will shift, changing the volume and the terms of trade. An
improvement in a nation's terms of trade is usually regarded as beneficial to the nation in the
sense that the prices that the nation receives for its exports rise relative to the prices that it
pays for imports.
For instance, if a nation's tastes change and desire for its import commodity increases, the
nation's offer curve will rotate closer to the axis measuring the commodity of its comparative
advantage. The reason for this is that the nation is now willing to give up more of its export
commodity in exchange for any given amount of the imported commodity because of its
increased desire for the imported commodity. This results in an expanded volume of trade but
in deterioration in the nation's terms of trade.
Figure 2.8 Shift in offer curve
As it has been shown in Figure 2.8, country I’s terms of trade deteriorate from Px/Py = 1 at
point E1 to Px/Py = 1/2 at point E2 and the volume of trade increases after country I's offer
curve shifts (rotates) from 1 to 1* as a result of its increased desire for its imported
commodity Y. The same would be true if an improvement in technology or an increase in
resources shifted country I's offer curve to 1* .
Similarly, an increase in country II's desire for imports of commodity X, an improvement in

its technology, or increased availability of resources over time will rotate country II's offer
curve upward (counter-clockwise). This will result in deterioration in country II’s terms of
trade and an expansion of trade. For example, if country II's offer curve rotates from 2 to 2*
while assuming no change in country I, then country II's terms of trade deteriorate from P y/Px
= 1 at point E1 to Py/Px = 1/2 (the inverse, or reciprocal, of Px/Py = 2) at point E3 and the
volume of trade expands.
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Heckscher-Ohlin Theory of Trade
The modern theory of international trade or the Heckscher-Ohlin (H.O.) theory was developed
by two Swedish economists, Eli Heckscher, and his student Bertil Ohlin, in 1920s. The H.O
theory states that the main determining factor for the pattern of production, specialization and
trade among countries is the relative availability of factor endowments and factor prices.
Regions or countries have different factor endowments and therefore have factor prices. Some
countries have much capital, others have much labor. The theory says that countries that are
rich in capital will export capital intensive goods and countries that have much labor will
export labor-intensive goods.
The Assumptions
The Heckscher-Ohlin theory is based on the following assumptions:
 It is a two-by-two-by-two mode: there are two countries (A and B), two commodities
(X and Y), and two factors of production (capital and labor).
 Both nations use the same technology in production.
 Commodity X is labor intensive and commodity Y is capital intensive in both
countries.
 Constant returns to scale in the production of both commodities in both countries.
 Incomplete specialization in production in both countries.
 Equal tastes in both countries: when relative commodity prices are equal in the two
countries, both countries will consume X and Y in the same proportion.
 Perfect competition in both commodities and factor markets in both countries.
 Perfect factor mobility within each country but no international factor mobility.
 No transportation costs, tariffs, or other obstructions to the free flow of international
trade.
Factor Intensity, Factor Abundance, and the Shape of the Production Frontier
Factor intensity: In a world of two commodities (X and Y) and two factors (labor and
capital), we say that commodity Y is capital intensive if the capital-labor ratio (K/L) used in
the production of Y is greater than K/L used in the production of X.
Note that it is not the absolute amount of capital and labor used in the production of
commodities X and Y that is important in measuring the capital and labor intensity of the two
commodities, but the amount of capital per unit of labor (i.e., K/L). For example, Country 1
can produce 1Y with 2K and 2L. Thus, K/L = 2/2 = 1 for Y. On the other hand, 3K and 12L
are required to produce 1X, in Country 1. Thus K/L = 1/4 for X. Since K/L is higher for
commodity Y than for commodity X, we say that commodity Y is capital intensive and com-
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modity X is L intensive in Country 1. If Country 2, K/L is 4 for Y and 1 for X. Therefore, Y is

the capital intensive commodity and X is the labor intensive commodity.
Factor abundance: There are two ways to define factor abundance.
i. In terms of physical units (i.e., in terms of the overall amount of capital and labor
available to each country).
ii. In terms of relative factor prices (i.e., in terms of rental price of capital and price of labor
time in each country).
Since we have assumed that tastes, or demand preferences, are the same in both countries, the
two definitions of factor abundance give the same conclusions in our case. That is, with
TK/TL larger in Country 2 than in Country 1 in the face of equal demand conditions (and
technology), PK/PL will be smaller in Country 2. Thus, Country 2 is the capital country in
terms of both definitions.
Figure 2.9 Shape of the production possibility curves
If Country 2 is the capital abundant country and commodity Y is the capital intensive
commodity, Country 2 can produce relatively more of commodity Y than Country 1.
Therefore, its production frontier, fig 2.9, is skewed toward the vertical axis measuring
commodity Y. On the other hand, Country 1 is the labor abundant country and commodity X
is the labor intensive commodity, Country 1 can produce relatively more of commodity X
than Country 2. This gives a production frontier for Country 1 that is relatively flatter and
wider than the production frontier of Country 2 (if we measure X along the horizontal axis).
The Heckscher-Ohlin Theory
Based on the assumptions of H-O theory presented before, the Heckscher-Ohlin theorem can
be stated as: A country will export the commodity whose production requires the intensive use
of the country's relatively abundant and cheap factor and import the commodity whose
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production requires the intensive use of the country's relatively scarce and expensive factor.
In short, the relatively labor-rich country exports the relatively labor-intensive commodity and
imports the relatively capital-intensive commodity.
Of all, the possible reasons for differences in relative commodity prices and comparative
advantage among countries, the H-O theorem isolates the difference in relatively factor
abundance, or factor endowments, among countries as theory determinant of comparative
advantage and international trade. For this reason, the H-O model is often referred to as the
factor-proportions or factor-endowment theory.
Illustration of Heckscher-Ohlin Theory
As indicated before, Country 1 is the L-abundant country and its production frontier is skewed
along the X axis because commodity X is the L-intensive commodity. Furthermore, since the
two countries have equal tastes, they face the same indifference map. Indifference curve I
(which is common for both countries) is tangent to Country 1's production frontier at point A
and to Country 2's production frontier at A'. Indifference curve I is the highest indifference
curve that Country 1 and Country 2 can reach in isolation, and points A and A' represent their
equilibrium points of production and consumption in the absence of trade.
The tangency of indifference curve I at points A and A’ defines the autarky, or no trade,
equilibrium relative commodity prices of PA in Country 1 and PA’ in Country 2. Since PA < PA’,
Country 1 has a comparative advantage in commodity X, and Country 2 has a comparative
advantage in commodity Y.
Figure 2.10 Hecksher-Ohlin Model
The right panel, Figure 2.10, shows that with trade Country 1 specializes in the production of
commodity X, and Country 2 specialize in the production of commodity Y (see the direction
of the arrows on the production frontiers of the two countries). Specialization in production
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proceeds until Country 1 has reached point B and Country 2 has reached point B' where the
transformation curves of the two countries are tangent to the common relative price line PB.
Country 1 will then export commodity X in exchange for commodity Y and consume at point
E on indifference curve II (trade triangle BCE). On the other hand, Country 2 will export Y
for X and consume at point E', which coincides with point E (trade triangle B'C'E').
Note that Country 1's exports of commodity X equals Country 2's imports of commodity X
(i.e., BC=C'E'). Similarly, Country 2's exports of commodity Y equals Country 1's imports of
commodity Y (i.e.; B'C'=CE). At, PX/PY > PB, Country 1 wants to export more of commodity
X than Country 2 wants to import at this high relative price of X, and PX/PY falls toward PB.
On the other hand, at PX/PY < PB, Country 1 wants to export less of commodity X than
Country 2 wants to import at this low relative price of X, and PX/PY rises toward PB. This
tendency of PX/PY could also be explained in terms of commodity Y.
Also to be noted is that point E involves more of Y but less of X than point A. Nevertheless,
Country 1 gains from trade because point E is on higher indifference curve II. Similarly, even
though point E' involves more X but less Y than point A', Country 2 is also better off because
point E' is on higher indifference curve II. This pattern of specialization in production and
trade and consumption will remain the same until there is a change in the underlying demand
or supply conditions in commodity and factor markets in either or both countries.
Factor-Price Equalization Theorem
The factor-price equalization theorem is a corollary of H-Q theorem and holds only if the H-O
theorem holds. It was Samuelson who rigorously proved this factor-price equalization
theorem. For this reason, factor-price equalization theorem is sometimes referred to as the
Heckscher-Qhlin Samuelson theorem (H-O-S theorem).
Based on the assumptions of H-O theory presented before, the factor-price equalization
theorem can be stated as: International trade will bring about equalization in the relative and
absolute returns to homogeneous factors across countries. Similarly, international trade will
cause the return (interest) to homogeneous capital (i.e., capital of the same productivity and
risk) to be the same in all trading countries. That is both relative and absolute factor prices
will be equalized.
Criticisms of H-O Theorem
Ohlin’s theory has been criticized on the following grounds:
 Two-by-two-by-two Model is oversimplified model. But, as Ohlin himself points out, it can
be extended to many regions, many commodities and many factors.
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 Static Theory. Like the classical theory, the Ohlin model is static in nature. It only gives
some characteristics of an economy at a given point in time
 Factors not Homogeneous. The theory assumes the existence of the homogeneous factors
in the two countries which can be measured for calculating factor endowment ratios. But,
in reality, no two factors are homogenous qualitatively between countries, and even one
factor is of various types.
 Production Techniques not Homogeneous. Again, the Ohlin model assumes homogeneous
production techniques for each commodity in the two countries.
 Tastes and Demand Patterns not Identical. The H.O theory is based on the assumption of
identical tastes and demand patterns of consumption in both countries.
 No Constant Returns. The assumption that there are constant returns to scale is also not
realistic because a country having rich factor endowments often obtains the advantages of
economies of scale through lesser production and exports. Thus there are increasing
returns to scale rather than constant.
 Transport Costs influence Trade. This theory does not consider transport costs in trade
between two countries.
 Unrealistic Assumptions of Full Employment and Perfect Competition. The H.O theory is
based on the unrealistic assumptions of full employment and perfect competition because
there is neither full employment nor perfect competition in any country of the world.
Rather, countries do not have free trade but impose trade restrictions on a large scale.
 Factor Prices do not determine Commodity Prices. Commodity prices are determined by
the factor prices which in turn, determine costs.
Despite these criticisms, the Ohlin theory of international trade is definitely an improvement over
the classical theory as it attempts to explain the basis of international trade in the general
equilibrium setting.
Learning activity
Assignment 1
Understanding and analysing the theories of international trade with regard to the basis and
gain from trade, debate and counter-debate on various theories of international trade
 Assignment (2 points)
Summary
The mercantilists believed that a nation could gain in international trade only at the expense
Page 26
of other nations. As a result, they advocated restrictions on imports, incentives for exports,
and strict government regulation of all economic activities.
According to Adam Smith, trade is based on absolute advantage and benefits both nations.
That is, when each nation specializes in the production of the commodity of its absolute
advantage and exchanges part of its output for the commodity of its absolute disadvantage,
both nations end up consuming more of both commodities. Absolute advantage, however,
explains only a small portion of international trade today.
David Ricardo introduced the law of comparative advantage. This postulates that even one
nation is less efficient than the other nation in the production of both commodities, there is
still a basis for mutually beneficial trade. Because, the less efficient nation could specialize in
the production and export the commodity in which its absolute disadvantage is least (this is
the commodity of its comparative advantage). Ricardo, however, explained his law of
comparative advantage in terms of the labor theory of value, which is unacceptable.
Letter Haberler explained the law of comparative advantage in terms of the opportunity cost.
The opportunity cost states that the cost of a commodity is the amount of a second commodity
that must be given up to release just enough resources to produce one additional unit of the
first commodity.
The offer curve of a nation shows how much of its import commodity the nation demands to
be willing to supply various amounts of its export commodity. The offer curve of a nation can
be derived from its production frontier, its indifference map, and the various relative
commodity prices at which trade could take place.
According to the Heckscher-Ohlin (H-O) theorem, a nation will export the commodity
intensive in its relatively abundant and cheap factor and import the commodity intensive in its
relatively scarce and expensive factor. According to the factor-price equalization theorem,
international trade will bring about equalization of relative and absolute returns to
homogeneous factors across nations.
3.2.3.3. SECTION THREE: INTERNATIONAL PATTERNS OF

TRADE AND SPECIALIZATIONS
The global economy has grown continuously since the Second World War. Global growth has
been accompanied by a change in the pattern of trade, which reflects ongoing changes in
structure of the global economy. These changes include the rise of regional trading blocs,
deindustrialization in many advanced economies, the increased participation of former
communist countries, and the emergence of China and India.
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Changes in the global economy
The main changes in the global economy are:
1. The emergence of regional trading blocs, where members freely trade with each other,
but erect barriers to trade with non-members, has had a significant impact on the
pattern of global trade. While the formation of blocs, such as the European Union and
NAFTA, has led to trade creation between members, countries outside the bloc have
suffered from trade diversion.
2. Like several advanced economies, the UK's trade in manufactured goods has fallen
relative to its trade in commercial and financial services. Many of these advanced
economies have experienced deindustrialisation, with less national output generated
by their manufacturing sectors.
3. The collapse of communism led to the opening-up of many former-communist

countries. These countries have increased their share of world trade by taking
advantage of their low production costs, especially their low wage levels.
4. Newly industrialised countries like India and China have dramatically increased their
share of world trade and their share of manufacturing exports.
Growth in international trade
Although subject to short term fluctuations as a result of the business cycle, the value of trade
has continued to grow, reflecting the increased significance of trade and globalization. Rapid
development of technologies, especially in transportation, has contributed the most in
increasing international trade.
World trade has grown steadily since World War II, with the expansion accelerating over the
past decade. Despite a post-crisis dip, the current level of world gross exports is almost three
times that prevailing in the 1950s (the figure below). With the exception of commodity-price
booms in the 1970s and more recently in 2004-2008, commodity trade accounted for a
declining share of this growth, with the share of no commodity trade rising to more than 20
percent of global GDP in 2008. The expansion in global trade was characterized by three
important trends: the rise of emerging market economies (EMEs) as systemically important
trading partners; the growing importance of regional trade; and the shift of higher technology
exports toward dynamic EMEs.
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Figure 3.1 World Exports Relative to Production (percent of GDP)
Where: the line on the top represents Total Exports and the line in the bottom represents non
commodity Exports.
Sources of change in the patterns of global trade
Trade liberalization: A key factor has been the multilateral and bilateral trade liberalization
since World War II, which resulted in a significant decline in trade barriers. Among major
Western European and North American countries, average tariffs fell from 15 percent to 4
percent during 1952-2005, with the bulk of this decline occurring during the 1950s and 1960s
(WTO, 2007). Tariffs increased or remained very high until the 1980s in many major
developing countries but have since come down sharply as well.
Increase in vertical specialization in production: Along with lower trade barriers,

technology-led declines in transportation and communication costs also allowed
fragmentation of production processes along vertical trading networks that stretch across
several countries. Technological advancement in communications reduces the cost of
oversight and coordination, making it easier to separate different stages of production across
countries. In addition, lower tariffs and transportation costs facilitate the flow of intermediate
goods across countries in the global supply chain, as each country specializes in particular
stages of a good’s production sequence.
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Convergence in income levels: As countries converged in income levels and in the

composition of their factor endowments, the volume of trade in relation to GDP increased.
Past Trends and Implications for Trade Outlook

The integration of rapidly growing EMEs is likely to induce a gradual shift in the sources of
global demand away from advanced economies. With China overtaking Japan as the second
largest economy in the world already in 2010, East Asian countries are likely to emerge as the
largest trading bloc by 2015, surpassing NAFTA and the Euro Area (the Figure below).
Global supply chains have been an important factor in this trend and a country’s position
along the supply chain could have important implications for trading patterns going forward.
Figure 3.2 Three Trading Blocks and top Export Markets by 2015 (share of World
nominal GDP): Where the first line stands for 2010 and the second for 2015
Learning activity
Assignment 1: how is the participation of Ethiopia in the international trade

performing? What are the sources of changes in its performance? What do you
recommend for a better performance?
Continuous Assessment: Test 1 (5 points)
Specialization and international trade
Given that the prices of products cannot be observed in conditions of autarchy, measuring
comparative advantages for the purpose of defining a country’s position in the international
division of labor becomes rather arduous. Even if one believes that, following the traditional
Page 30
approach of the neoclassical theory, a country’s international specialization is determined by

its relative endowment of production factors.
Factors underlying a country’s comparative advantages not only affect the commodity
composition of its trade flows, but also the overall structure of its economic activities and
their degree of international openness. This raises the need to evaluate a country’s
international specialization by taking into consideration both its foreign trade and its main
internal economic variables (production and demand).
Indicators of specialization
1. Normalized trade balance
2. Index of contribution to the trade balance
3. Trade specialization index
All of these indicators refer to trade specialization, while a more thorough understanding of a
country’s position in the international division of labour would require measuring production
specialization, defined in terms of the gap between internal production and demand for each
good.
Improvements in transport, telecommunications and information technology, together with

increased economic integration and greater trade openness, have resulted in higher levels of
technological diffusion and increased mobility and accumulation of productive factors over
time. As a result, countries have become less specialized in the export of particular products,
and therefore more similar in terms of their export composition. Comparative advantage, or
international differences in relative efficiencies among products, has become weaker over
time in many countries, just as comparative advantage has shifted geographically. For
example, Ethiopia was almost specialized in coffee export until recently where other
commodities are also included. On the other hand some countries are still striving towards
specialization based on the abundant resource that is available to them (eg. India on
technological services) (Alessandrini et.al. 2007).
Learning activity
Assignment 2: discuss the changes in international trade after the World War II with
your friends.
Summary
After the World War II trade has been increasing steadily. Some of the reasons, among many,
are trade liberalization, increase in vertical specialization and convergence of income among
countries. The trade control is shifting from the NAFTA and EU to the emerging economies
such as China. Although specialization is based on the comparative advantage of countries
based on their resource endowments, some countries prefer to be less specialized. This is
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possible because of the improvements in technology, especially, in transportation and

communication.
3.2.3.4. SECTION FOUR: THEORY OF TRADE PROTECTION
Have you ever heard of free trade? How about trade protection?
Concepts and arguments of Protectionism
Protection implies granting a protective cover to the home industries against foreign
competition either by imposing duties on the foreign goods or by helping the domestic
industries by giving subsidies and making raw materials available at subsidized prices.
Generally, protection of industries may involve:
i) Levying of import duties which may raise price of foreign goods relative to domestic
goods; or
ii) Fixing of quotas or posing of non-tariff restrictions, which make the entry of cheap
foreign goods difficult or impossible; or
iii) Granting of subsidies or reward to the domestic industries to enable them to compete
with cheap foreign goods.
Arguments in Support of Protection Policy
Infant industry argument: According to this argument industries which are in their infancy
should be protected against foreign competition because they are not strong enough to
compete with the well established foreign industries. The main idea behind this argument is
that free trade among unequal is not at all desirable.
Diversification of Industries Argument: Protection helps in the diversification of industries

in a country. From political point of view, countries should be self sufficient. From economic
point of view, diversification reduces risk.
Employment Argument: A policy of protection stimulates economic activity and raises the
level of employment in the country.
Terms of Trade Argument: It is held that protection improves a country's terms of trade and
enables it to secure larger gains from international trade. Imposition of tariffs raises the price
of imports in the country that imposes tariffs. This decreases demand for imported goods
which compels the producers in the exporting country to lower the price of their products and
reduce the foreign supply to match the reduced demand in the country imposing tariffs.
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Bargaining Argument: The protagonists of protection argue that it increases the bargaining
power of the country in international trade. It means that if tariffs are imposed by a country, it
can force other countries to lower their tariff duties and thus enable that country to obtain
favorable terms for its exports from other countries.
Balance of Payments Arguments: It is held that protection helps the countries in removing
the disequilibrium in their balance of payments. In order to correct the imbalance in the
balance of payment a country by imposing tariffs can have an excess of exports over imports
and will thus earn more foreign exchange.
Anti-Dumping Argument: Dumping means that the foreign country dumps the domestic
market with its goods at a very low price, even lower than what that country receives in its
own market. Consequently, dumping is detrimental to a country in which it occurs. It ruins the
competing firms in the importer country.
Revenue Argument: It is held that protection is a good device for increasing revenues of the
government. In the first place, imposition of tariff protects the home industries as well as
brings revenue to the government.
Capital Formation Argument: Protection can also lead to the promotion of capital formation
by increasing the saving ratio in the country. Increase in tariff may increase the domestic
saving ratio by: providing better terms of trade, attracting foreign investment, and by
increasing saving through a cut in consumption.
Self-sufficiency Argument: This argument has been advanced in favor of protection as a

source of attainment of national self-sufficiency and for providing protection to the country
from outside disturbances.
Basic Industry Argument: Power is essential for the development of basic and key
industries like iron and steel. Protection can help in the development of such industries and
thus promote industrialization.
Maintaining High Wage Argument; A policy of protection has been advocated to protect
the interest of the domestic workers. It is held that competition from a high wage country
with a low wage country will create problems to both the countries. But a policy of
protection enables the high wage countries to compete with the low wage countries.
Defense Argument: Protection is necessary for the development of national defense

industries particularly for meeting war time situations. In fact national security and
maintenance of the sanctity of national frontiers are more important than economic prosperity
or economic development. Even Adam Smith said that defense is better than opulence.
Page 33
Nationalist Argument: Protection creates a spirit of nationalism and patriotism in the people,
and stimulates the development of domestic industries by restricting imports through
protective measures.
Preservation Argument: Protection is also supported for the preservation of particular

groups of people and particular occupations. For example, in under developed countries like
India agriculture forms the backbone of the society and, therefore, by levying tariff duties on
the import of cheap food grains, mainly for protecting the agriculturists, would be justified.
Arguments against Protection
 Loss of Revenue. The imposition of protective tariffs reduces imports and consequently
the revenue of the government from customs duties declines.
 Uneconomic Use of Resources. Since protection may lead to the development of
economically less efficient industries, the resources would be transferred from more
productive use to less productive use.
 Prevents Industrial Growth. Protection once granted cannot be easily withdrawn
because of vested interests. Protection in fact becomes a permanent feature and the
protected industry continues to remain an infant industry. .
 Producers become Lethargic. The absence of competition owing to the adoption of
policy of protection makes the home producers lethargic. They do not care to improve
their efficiency or reduce the cost of their production.
 No Increase in the Level of Employment. Protection may also not lead to generate
employment because whatever jobs will be created in the protected domestic industries
will be balanced by a fall in the employment in export industries.
 Loss to Consumers. Protection leads to restrict imports and increase domestic prices and
ultimately makes the consumers to suffer.
 Unequal Distribution of Income. Protection makes the rich, richer and poor; poorer. The
rich enjoy larger benefits and the poor suffer because of increase in prices. Thus
protection aggravates inequalities in the distribution of wealth. .
 Creation of Monopolies. Imposition of tariff leads to the growth of monopolistic
tendencies. Since there is no foreign competition, domestic producers enjoy monopolistic
gains by earning high profits.
 Tariff Wars. By imposing protective tariffs a country forces other trading partners also to
impose tariffs on their imports as a retaliatory measure. This ultimately results in tariff
war.
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Means of Trade Restriction
Meaning and Types of Tariffs
Tariff refers to a tax or duty levied by the government of a country on goods and services
entering foreign trade. When a duty is imposed on a commodity at the time of its leaving the
national border, it is called 'export duty' and when it is levied on the goods entering the
national border, it is called 'import duty'. There are four types of tariffs.
 Specific Duty. It is a fixed sum of money imposed as a duty on a commodity

according to its weight or measurement (physical dimensions) as Birr. X per unit or per
meter or per liter, etc.
 Ad valorem Duty. It is imposed as a percentage of the value of the imported
commodity. The value is inclusive of insurance plus freight charges, that is, cost of the
commodity plus insurance and freight charges, represent the total value of a commodity
on which, the duty is charged.
 Compound Duty. A combination of both specific and ad valorem duties is a

compound duty levied on a commodity.
 Sliding Scale Duty. It is levied on the basis of the price of the imported commodity
rising and falling with an increase or decrease in the price. It can be specific or ad valorem
but mostly it is specific.
Meaning and Types of Quotas
Quotas are a device under which limit is fixed in respect of either the value or the quantity of
a commodity that may be imported or exported by a country during a specified period of time,
usually one year. The prime objective is the quick and effective regulation of imports and
exports.
Import quotas are often used to protect: i) domestic industries from foreign competition; or ii)
to correct a disequilibrium in the balance of payments; or iii) for commercial bargaining; or
iv) to execute barter deals with different countries.
Export quotas may be used for (i) equitable distribution of scarce export, ii) regulation of
exports of essential raw materials; or iii) to execute international export agreements.
A country may use different types of quotas, which includes:
 Tariff Quotas: Under this system a country may allow the imports of a specified
quantity of a commodity either duty free or at a very low duty. Beyond this limit a high
rate of duty is charged.
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 Unilateral Quotas: Under this a country may unilaterally fix a quantity or value of a
commodity either through legislation or by decree that can be imported. It is global if a
specific commodity can be imported from any part of the world.
 Bilateral Quotas: When the quotas are fixed by mutual agreement between the
countries, it is known as bilateral quota system. Such a system works more smoothly than
the unilateral quota system.
 Mixing Quotas: When the domestic producers are made to use the imported raw
material in a fixed proportion with domestic raw material in the production of a
commodity and quotas for the import of specified raw material are fixed on this basis the
quotas are called 'mixing quotas'.
Meaning and types of Subsidies
National governments sometimes grant subsidies to their producers to help improve their
trade position. By providing domestic firms a cost advantage, a subsidy allows them to market
their products at prices lower than warranted by their actual cost or profit considerations.
There two types of subsidies: a domestic subsidy, which is sometimes granted to producers of
import-competing industries and an export subsidy, which goes to producers of goods that are
to be sold overseas.
Learning activity
Assignment 3
China has taking the lion share of international market by devaluing its national currency. As
a counter active measure, USA has now considering the imposition of non tariff barriers on
the goods coming from China. What are the likely impact of both tariff and non tariff barriers
in smoothing/&hindering the volume of trade between China and USA?
 Assignment 3 (3 points)
Summary
Protection implies granting a protective cover to the home industries against foreign
competition. The policy of protection may comprise of a number of measures like tariffs, im-
port quotas, import restrictions, expenditure control, subsidies, devaluation, etc. Which of
these methods of protection would be in the interest of a country and which one should be
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adopted will largely depend upon the objectives in view. Tariffs and quotas are the two most
commonly used methods of protection.
3.2.3.5. SECTION FIVE: ECONOMIC INTEGRATION
What does Regional Trading Arrangement mean?
Types of regional trading arrangements
Economic integration is a process of eliminating restrictions on international trade, payments

and factor mobility. Economic integration thus results in the uniting of two or more national
economies in a regional trading arrangement. There are different degrees of economic
integration (regional trading arrangements). Below are the different types of economic
integration.
1. Free- trade area. This is an association of trading nations whose members agree to
remove all tariff and non- tariff barriers among themselves. Each member, however,
maintains its own set of trade restrictions against outsiders. An example of this stage of
integration is the North American Free Trade Agreement (NAFTA), consisting of Canada,
Mexico and the US.
2. Customs Union. A second stage in the process of economic integration is the formation
of customs union. Like a free trade association, a custom union is an agreement among
two or more trading partners to remove all tariff and non- tariff trade barriers among
themselves. In addition, however, each member nation imposes identical trade restrictions
against non participants. That is, each nation follows a common external trade policy.
The effect of the common external trade policy is to permit free trade within the customs
union, while all trade restrictions imposed against outsiders ( non- members) are
equalized.
3. Common Market. A further stage in the process of economic integration is a common
market. A common market is a group of trading nations that permits;The free movements
of goods and services among member nations, The initiation of common external trade
restrictions against non members and The free movement of factors of production across
national borders within the economic bloc (group). The common market, thus, represents
a more complete stage of integration than a free-trade area or customs union. The
European Union (EU) achieved the status of a common market in 1992.
4. Economic Union
This represents an even further step in economic integration than a common market. In
addition to permitting free movement of goods, services and factors of production, and
following a common external trade policy against non members, national, social, taxation
and fiscal policies are harmonized and administered by a supranational institution in
economic union. In other words, in addition to abolition of existing trade barriers,
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economic union requires an agreement to transfer economic sovereignty to a super natal

authority.
5. Monetary Union
This represents the ultimate degree of economic union and it requires the unification of
national monetary policies and the acceptance of a common currency administered by a
supranational monetary authority. The U.S. serves as an example of a monetary union.
Fifty states are linked together in a complete monetary union with a common currency,
implying completely fixed exchange rates among 50 states.
Reasons for Regionalism
A motivation of virtually every regional trading arrangement has been the goal of enhanced
economic growth. An expanded regional market can allow economies of large scale
production, foster specialization and learning- by –doing, and attract foreign investment.
Regional initiatives can also foster a variety of non economic objectives, such as managing
immigration flows and promoting regional security.
Moreover, smaller nations may seek safe- haven trading arrangement with larger nations
when future access to the larger nations’ markets appears uncertain. This was an apparent
motivation for the formation of NAFTA. In North America, Mexico was motivated to join
NAFTA partially by fear of changes in the U.S trade policy towards a more managed or
strategic trade relation.
Effects of a regional trading Arrangement
Static effects:To understand the static welfare effects of customs union, assume a world
composed of three countries: Luxembourg, Germany and U.S. Suppose that Luxembourg and
Germany decide to form a customs union, and the U.S. is a non member. The decision to form
a custom union requires that Luxembourg and Germany abolish all tariff restrictions between
themselves while maintaining a common tariff policy against the US. Referring to the
following figure, assume the static welfare effect of a customs union.
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Price ($) SL
SG+ tariff
3.75
SUS+ tariff
3.5 C
a
b SG
3.25
SU
3.00 S
DL
Grain
1 4 7 17 (bushels)
20 23
Figure 5.1 Static Welfare Effects of a customs Union
The formation of customs union leads to a welfare- increasing trade- creation effect and a
welfare-decreasing trade-diversion effect. The overall effect of the customs union on the
welfare of its members, as well as on the world as a whole, depends on the relative strength of
these two opposing forces.
Let Supply and demand schedules of Luxembourg be S L and DL. Assume also that
Luxembourg is very small relative to Germany and the U.S. This means that Luxembourg
cannot influence foreign prices, so that foreign supply schedules of grain are perfectly elastic.
Let Germany’s supply price be $3.25 per bushel and that of US $3 per bushel. Note that the
US is assumed to be the more efficient supplier as it can offer the grain at a lower price.
1. Before the formation of the customs union (and under the conditions of free trade),
Luxembourg finds it advantageous to purchase all of its import requirements from the
United States. Germany doesn’t participate in the market because its supply price
exceeds that of the US. In free – trade equilibrium, Luxembourg’s consumption equals
23 bushels, production equals 1 bushel, and imports equal 22 bushels.
2. Now suppose Luxembourg levies a tariff 50 cents on each bushel imported from the
United States (or Germany). This raises the Germany’s supply price to $ 3.75 and the
United States supply price to $ 3.5 still, Luxembourg will find it advantageous to import
from US. But since the imposed tariff has increased the price, Luxembourg imports less
bushels of grain (the level of import decreases from 22 bushels to 10 bushels)
3. Now suppose that, as part of a trade liberalization agreement, Luxembourg and Germany
form a customs union. Luxembourg’s import tariff against Germany is dropped, but it is
still maintained on imports from the non member united states. This makes Germany a
low- price supplier and Luxembourg now purchases all of its imports (16 bushels) from
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Germany at $ 3.25 per bushel, while importing nothing from the US. The movement
towards free trade under a customs union affects world welfare in two opposing ways:
- A welfare – increasing trade- creation effect and

- A welfare – reducing trade – diversion effect
To distinguish the welfare effects of customs union, we compare the equilibrium condition
after the formation of customs union with the equilibrium condition before formation customs
union when Luxembourg has imposed a uniform tariff on both U.S and Germany.
Trade creation occurs when some domestic production of one customs – union member is
replaced by another member’s lower- cost imports. In our example, trade- creation occurs
when the Luxembourg’s domestic production of grain is replaced by the Germany’s lower-
cost imports. That is, before the formation of customs union Luxembourg used to produce 7
bushels of grain, while importing 10 bushels from US. After the formation of customs union
agreement with Germany, Luxembourg can now import grain at $ 3.25 per bushel. This
reduces domestic production from 7 bushels to 4 bushels in Luxembourg. Hence, customs
union agreement between Germany and Luxembourg has the effect of increased production
specialization in Germany according to the principle of comparative advantage. This increases
the welfare of both countries: Luxembourg consumers are now paying a lower price ($3.25
per bushel) than before ($3.5 per bushel) and Germany’s producers have now got the chance
to produce more and export their product.
The trade creation effect consists of a consumption effect and a production effect.
Consumption effect
Before the formation of customs union and under its own tariff umbrella, Luxembourg
imports from the US at a price of $ 3.50 per bushel. Luxembourg’s entry into the customs
union results in its dropping all tariffs against Germany. Facing a lower import price of $
3.25, Luxembourg increases its consumption of grain by 3 bushels (from 17 to 20 bushels).
The welfare gain associated with this increase in consumption equals area of triangle b in the
above figure.
Production effect
Eliminating the tariff barrier against Germany means that Luxembourg producers must now
compete against lower- cost, more efficient German producers. Inefficient domestic producers
drop out of the market, resulting in a decline in home output of 3 bushels (from 7 to 4
bushels). The reduction in the cost of obtaining this output (the 3 bushels) equals triangles a in
the figure. This area represents the favorable production effect. The overall trade- creation
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effect is given by the sum of triangles a + b. Although a customs union may add to the world
welfare by trade creation, its trade diversion effect generally implies a welfare loss.
Trade diversion occurs when imports from a low cost supplier outside the union (U.S) are
replaced by purchases from a higher cost supplier within the union (Germany). This suggests
that world production is reorganized less efficiently. This is area c, the welfare loss to
Luxembourg and the world as a whole.
Generally speaking, our static analysis concludes that the formation of a customs union will
increase the welfare of its members, as well as the rest of the world, if the positive trade-
creation effect more than offsets the negative trade- diversion effect. Referring to the figure,
this occurs if a + b is greater than c.
Dynamic effects of customs union
However, not all welfare consequences of regional trading arrangements are static in nature.
There may also be dynamic gains that influence member- nation growth rates over the long-
run. These dynamic gains stem from the creation of larger markets by the movement to freer
trade under customs unions. The benefits associated with a customs union’s dynamic gains
may more than offset any unfavorable static effects. The dynamic gains include economies of
scale, greater competition and a stimulus of investment.
Learning activities
Problem based learning tasks
Based on the concept of regionalism, Diagnose and explain the limitations in trade unions
(COMESA, SADC, and ECOWAS).
Assignment 4
One of the reasons for many Regional Trade Arrangements (RTAs) in developing countries to
fail in achieving their specific objectives can be traced directly to their strategy based on
import-substitution towards industrialization. The inward-oriented strategy has failed
consistently to expand trade and industry within RTAs). Examine the validity of this
statement.
 Assignment 4 (2 points
Summary
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Economic integration, the process of eliminating restrictions on international trade, payments,

and factor input mobility, has several stages including free-trade area, customs union,
common market, economic union, and monetary union.
The static welfare effect of regional integration depends on the magnitudes of the welfare
increasing trade creation and the welfare reducing trade diversion effects. The dynamic
welfare effect of regional integration is favorable, and it stems from greater competition,
economies of scale, and stimulus to investment spending.
3.2.3.6. SECTION SIX: BALANCE OF PAYMENT, DIS-EQUILIBRIUM AND

ADJUSTMENT
Balance of payments accounting and accounts
An important point about a country's balance-of-payments statistics is that in an accounting

sense they always balance. Each receipt of currency from residents of the rest of the world is
recorded as a credit item (a plus in the accounts) while each payment to residents of the rest
of the world is recorded as a debit item (a minus in the accounts). Let’s first consider the
various sub accounts that make up the balance of payments:
A) Current account: Can be divided into two sub accounts: visible and invisible
accounts. The visible subaccount records the values of imported and exported goods
where as the invisible sub-account records values of imported and exported services;
interests, profits and dividends received; interests, profits and dividends paid;
unilateral receipts and payments. The balance on the visible accounts of the current
account is termed as the trade balance whereas the sum of the visible trade balance and
the invisible balance is termed as the current account balance
Trade Balance = Receipts for exported goods – Payments on imported goods
Current Account Balance = Trade balance + Invisible Balance
B) Capital account: The capital account records transactions concerning the movement
of financial capital into and out of the country. Capital comes into the country by
borrowing, sales of overseas assets, and investment in the country by foreigners. These
items are referred to as capital inflows and are recorded as credit items in the balance
of payments. Capital inflows are, in effect, a decrease in the country's holding of
foreign assets or increase in liabilities to foreigners. The fact that capital inflows are
recorded as credits in the balance of payments often presents students with difficulty.
Capital Account Balance = Capital Inflows – Capital Out flows
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Official settlements balance
The summation of the current account balance, capital account balance and the statistical
discrepancy gives the official settlements balance. The balance on this account is important
because it shows the money available for adding to the country's official reserves or paying
off the country's official borrowing. A central bank normally holds a stock of reserves made
up of foreign currency assets. Such reserves are held primarily to enable the central bank to
purchase its currency should it wish to prevent it depreciating. Any official settlements deficit
has to be covered by the authorities drawing on the reserves, or borrowing money from
foreign central banks or the IMF (recorded as a plus in the accounts). If, on the other hand,
there is an official settlements surplus then this can be reflected by the government increasing
official reserves or repaying debts to the IMF or other sources overseas (a minus since money
leaves the country).
Balance of Payments Surplus or Deficit
Balance of payments always balances since each credit in the account has a corresponding
debit elsewhere. When talking about a balance-of-payments deficit or surplus economists
are really saying that a subset of items in the balance of payments is in surplus or deficit.
Alternative Concepts of Balance of Payments Surplus and Deficits

a) The trade account and current account
These two accounts derive much of their importance because estimates are published on a
monthly basis by most developed countries. Since the current account balance is concerned
with visible and invisible, it is generally considered to be the more important of the two
accounts. What really makes a current account surplus or deficit important is that a surplus
means that the country as a whole is earning more than in it spending visa-vis the rest of the
world and hence is increasing its stock of claims on the rest of the world; while a deficit
means that the country is reducing its net claims on the rest of the world. Furthermore, the
current account can readily be incorporated into economic analysis of an open economy.
More generally, the current account is likely to quickly pick up changes in other economic
variables such as changes in the real exchange rate, domestic and foreign economic growth
and relative price inflation
b) The basic balance
This is the current account balance plus the net balance on long-term capital flows. It was
argued that any significant change in the basic balance must be a sign of a fundamental
change in the direction of the balance of payments, which is not the case always.
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Training of general skills
Training by an experienced banker on international transfer of finance (i.e. the features of

import-export payment) and on how to keep records of balance of payments
Summary
The balance of payments is a statistical record of all the economic transactions between
residents of the reporting country and residents of the rest of the world. Each receipt of
currency from residents of the rest of the world is recorded as a credit item (a plus in the
accounts) while each payment to residents of the rest of the world is recorded as a debit item
(a minus in the accounts). Deficit in the official settlement balance implies that the sum of
inflows of income and capital into the country is less than the sum of the outflows of income
and capital from the country and vise versa. A country will apply official financing sources
provided that the country follows a fixed exchange rate policy. Positive balance in the official
financing balance implies that there is a decrease in the reserve level of the country and/or the
country has borrowed money from IMF implying an increase in liabilities.
3.2.3.7. SECTION SEVEN: FOREIGN EXCHANGE MARKET
Ethiopia’s exchange rate policies have been a bone of contention for concerned economic
analysts and commentators alike. The surprise devaluation of the birr on August 2010 from a
value of 13.63 to the US dollar to 16.35 was apparently undertaken to boost export
performance and bring about structural change in the economy.
The Concept of Exchange Rate:
The foreign exchange rate or exchange rate is the rate at which one currency is exchanged for
another. Exchange rate can be quoted in two ways: i) One unit of foreign money to a certain
number of units of the domestic currency (direct quote). Example $1= 17 Birr and, ii) A
certain number of units of foreign currency to one unit of domestic currency. (The indirect
quote). Example 1 Birr = $ 0.059.
Supply, demand and market for foreign exchange
The value of a nation’s money, like most goods and services, can be analyzed by looking at its
supply and demand. For example an increase in the demand for the dollar will raise its price
(cause an appreciation in its value), while an increase in its supply will lower its price (cause a
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depreciation). These are only tendencies, however, and depend on other factors remaining
constant.
A) Demand for foreign exchange: The exchange rate is measured on the vertical axis
and quantity of the foreign currency (US$) is measured on the X-axis. The exchange
rate R is a measure of the price of the foreign currency (US$) in terms of domestic
currency (Ethiopia Birr). A increase in R implies a decline in the value of Birr and an
increase in the value of US$.
Exchange
rate
B
1
B2
B3
Demand for foreign
exchange foreign
(Dollar)
Dollar
1000 2000 3000
Figure 7.1 shows the demand for US $ in Ethiopia
B) Supply curve for foreign exchange
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The supply curve of foreign currency slopes up because consumers are willing to buy a
greater quantity of domestic goods as the domestic currency becomes cheaper.
Exchange rate (Birr/Dollar)
Supply of
Dollar
20,000 50, 0000 90, 000 Dollar
Figure 7.2 Supply of foreign exchange
C) The market for foreign exchange
Figure 7.3 shows (combines) the supply and demand curves of foreign currency. The
intersection of the curves in the Ethio-US foreign exchange market determines the exchange
rate R1 at which the quantity of demand and supply of foreign currency to the Ethiopian
Economy are equal.
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Foreign exchange rate
Supply of
Dollar
R3
R2
R3
Demand for Dollar
Q0 Quantity of Dollar
Figure 7.3 Equilibrium in foreign exchange market
Change in demand and supply of foreign exchange
There are three major reasons why people hold foreign currency rather than their own. i) For
reasons related to trade and direct investment (like business cycle, inflation and expectation of
future economic growth), ii) to take advantage of interest rate changes and iii) to speculate.
Changes in one or more of these three motives for holding foreign currencies can lead to a
shift in the demand and supply curves.
Table 7.1 Major determinates of the supply and demand for foreign currency in
Ethiopia.
Factors Increase in demand of Increase in supply of

Ethiopia for foreign exchange foreign exchange
1) Trade and direct Ethiopian economic expansion ( Foreign economic
investment factor more Ethiopians export) expansion ( more Ethiopians
b) The business cycle export)
c) Inflation Ethiopian inflation ( foreign Foreign inflation ( Ethiopian
goods are relatively cheaper) goods relatively cheaper)
d) Expectation of Increased potential for foreign Increased potential for
future growth growth (attracts outward Ethiopians growth (attracts
Ethiopian direct investment) foreign direct investment in
Ethiopia)
2) Interest rate changes An increase in foreign interest An increase in Ethiopian
rate/ decline in Ethiopian interest rate/ decline in
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interest rate foreign interest rate

3) Speculation Expectation of a future decline Expectation of a future rise
in value of Birr/ a future rise in the value of Birr/ a
value of foreign currency future decline value of
foreign currency
Nominal and Real Exchange Rates
From the point of view of tourists and business people who use foreign exchange, the key
item of interest is the purchasing power that they get when they convert their dollars, not the
number of units of a foreign currency. An American importer trying to decide between
Ethiopia and Kenyan textiles does not care if he or she gets 8.7 birr per dollar or 73.2 KES per
dollar. The biggest concern is the volume of textiles that can be purchased in Ethiopia with
8.7 Birr and in Kenya with 73.2 KES.
Real Exchange Rate is the market exchange rate (nominal exchange rate) adjusted for
inflation.
Rr = Rn (PF/PH) ----------------------------------------- (1)
Where Rr = real exchange rate, Rn = market (nominal) exchange rate, PH= home country
price level, PF = foreign country’s price level
A base year is arbitrary chosen as a standard for comparison, and PL and PF are both equal to
100 at the base year. Thus, the base year real exchange rate is:
Rr = Rn (100/100) = Rn ------------------------------ (2)
Over time, if inflation is higher at home than in the foreign country, then PH rises more than
PF, and Rr falls if Rn is constant. This means: Domestic currency appreciates in real terms
and Foreign currency depreciates in real terms.
Example: The base year nominal or market exchange rate in the Ethio-US foreign exchange
market is 8.7 birr per USD. After a year there has been 10% inflation in Ethiopia while the
inflation in USA is zero percent. Calculate the real exchange rate.
Rr = Rn (PF/PH)
= 8.7 (100/110)
= 7.91 Birr/USD
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Determinates of Exchange Rate in the Long-Run
In the long run, exchange rates are determined by two main factors: i) Purchasing Power
Parity (PPP) and ii) Differences in productive growth between countries.
Purchasing power parity: Purchasing power parity also termed as law of one price, states
that a currency should buy the same quantity of goods when converted to another currency as
it can buy at home.
Differences in productivity growth rates: Faster productivity growth is equivalent to a

relative decline in prices and leads to a real appreciation in currency values over the long run.
3.2.3.7.3. Exchange Rate Systems
Exchange rate systems are the rules that nations attach to the movement of their exchange
rates. There are a number of different categories of sets or rules that nations may adopt, but
they all are modifications of two fundamental categories. I) Fixed exchange rate system and
II) Floating exchange rate system.
Devaluation is a decline in the value of a currency under a fixed exchange rate system, while
depreciation is a decline under a flexible system.
Revaluation is an increase in the value of currency under a fixed exchange rate system while
an appreciation is an increase in the value of currency under a flexible exchange rate.
Exchange Control
It should be noted at the very outset that, exchange controls, like currency devaluations, form
a part of expenditure-switching policy package. Because, they too, like devaluation, aim at
directing domestic spending away from foreign supplies and investment. Exchange controls
try to divert domestic spending into consumption of domestically produced goods and
services on the one hand and into domestic investment on the other.
Objectives of exchange control
The object of controlling exchange is to fix it at a level different from what it would be if the
economic forces were permitted free interplay. The objectives of exchange control could be
to:
 correct a serious imbalance in the economy of the country relatively to the outside
world; or
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 permit national economies and policy architects a broad freedom of action both in
emergency and normal economic situations and warranty the decision to pursue
domestic policies of economic growth and development; or
 correct a persistently adverse balance of payments; or
 prevent a flight of capital from the country; or
 conserve foreign exchange reserves for large payments abroad, i.e facilitate servicing
of foreign debt; or
 maintain stable exchange rate, or to ensure growth with stability, and so on
In all these circumstances, a free exchange would be either embarrassing or prejudicial to the
object in view, and exchange control becomes an imperative necessity.
Methods of exchange control
Exchange controls may be broadly classified into two groups - direct and indirect exchange
controls. Among the direct methods mention may be made of intervention and regulation in
matters concerning exchange rates, foreign exchange restrictions, multiple exchange rate
policies etc. Indirect methods of exchange control include import tariffs, export subsidies,
bilateral & multilateral clearing arrangements, etc.
A. Direct methods of exchange control
1. Foreign exchange rate regulation through intervention
The government may intervene in the foreign exchange market with a view to raise or reduce
the external value of its home currency. Since both depreciation and appreciation of currency
are regarded as undesirable, there is need for government intervention in keeping exchange
rates relatively stable. Exchange rate stability is necessary to facilitate and promote healthy
growth of international trade and capital movements.
2. Exchange restrictions
This is another, and perhaps more severe form of exchange controls. In this case, all foreign
exchange earnings and receipts must be surrendered to the government and exchanged for
home currency; and foreign exchange can be purchased only from the government authorities.
Non-compliance with currency transactions and regulations laid down by the governments are
crime.
3. Multiple exchange rate policies
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The policy of multiple exchange rates is also called selective devaluation policy as opposed
to general devaluation policy. In the case of general devaluation policy, imports of all goods
and services are made expensive, regardless of whether they are essential or nonessential
types of imports. Similarly, generally devaluation would make all the exports attractive
regardless of what the export commodity is. Multiple exchange rate policy undertakes
selective devaluation i.e. it would make essential imports cheaper and nonessential imports
expensive, and it would make some exports attractive and other exports unattractive.
B. Indirect methods of foreign exchange control
1. Exchange clearing agreements
Exchange clearing agreements can be bilateral or multilateral, private or official. The world
has witnessed all such different types of agreements over the past several years. Bilateral
clearing arrangements lead to a system of international trade and payments of a barter nature.
Among the earliest forms of bilateral trade were barter deals undertaken by private firms. If
all exports and imports of a country are carried out in such a bilateral barter fashion, there
would be no BOP deficits or surpluses in any country. There would even be no need to use
money or foreign exchange in settling international trade and payment obligations. Such
bilateral clearing arrangements are employed by Communist countries in trading with one
another.
2. Tariffs and quotas
Import duties levied for revenue consideration or to stimulate domestic industrialization, can
be considered as indirect exchange control methods. Similarly, export subsidies with a view to
expand exports need not necessarily fall into the category of exchange controls. Only when
the objective of import duties or quotas or export duties or subsidies is explicitly to support
the foreign exchange rate or improve the BOP situation, can they be truly considered as
indirect methods of exchanges control. In reality, however, it is very difficult to identify
whether a given important tariff or export subsidy is introduced for considerations of revenue
or foreign exchange earnings (saving to improve BOP situation). The same kind of difficulty
extends also to non-tariff barriers which a country may impose.
Learning activity
Assignment 6
Debate on the controversial issues of devaluation! Can devaluation of Ethiopia’s birr hasten
Ethiopia’s export flows?
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Summary
The three major factors for a change in demand and a change in supply of foreign currency
are trade and direct investment related factors, changes in interest rates in the foreign and
home country, and speculation. Purchasing Power Parity and differences in productivity
growth between countries are the major determinants of changes exchange rate over the long
run. The major objectives of exchange control as a policy by most developing countries is to
correct balance of payment problems, to allow policy makers and governments a freedom of
action in policy making and implementation, prevent illegal capital flight, conserve foreign
exchange reserves for large payments abroad, to facilitate debt servicing, and maintain stable
exchange rate to encourage growth with stability. The direct methods of exchange control
include foreign exchange regulation through intervention, foreign exchange restrictions, and
multiple exchange rate policies (selective devaluation). Exchange clearing agreement, tariff
on imports, import quotas, and import restrictions are the main instruments that can be
considered as indirect methods of exchange control.
3.2.4. Proof of ability
Instructors or responsible figures are expected to assess whether the knowledge and skills the
students have gained from the educational units are aligned to the practical situation. The
following table shows assessment plan that helps to assess the student.
Relation with
Performance criteria Indicator Category (method of
assessment) competencies
1. Explaining the Detail description Written test, rubrics, quiz,
different theories for different assignment, criteria based To explain
of international theories of interview
trade with respect international trade
to basis and gain are given
from trade
2. To understand the Describe how Individual and group

patterns of international trade is written To understand
international trade changing, why and Assignment (seminar),
and its future what will be its written tests, criterion
prospect future. based interview
Page 52
3. Conceptualize Critically evaluate Individual assignment

customs union, and and group To understand
and trade policies. categorize custom work, written tests,
unions, problem analysis or case
applying theories analysis
and
principles
adequately
4. Explaining the The core concepts Individual and group
concepts of of balance of written To explain
balance of payment and assignment, written tests,
payment and foreign exchange criterion based interview
foreign exchange discussed
References
1. Robert J. Carbaugh .2004. International Economics, 9th edition.

2. HG Mannur .1995. International Economics, 2nd revised edition.
3. Krugnan, Paul and Maurue Obstfeld.1997.International Economics: Theory and
Policy, Addison-Wesley press
4. B. Sodersten.1980. International economics 2nd Edition,Macmillan press, London
5. Hajela, T.N.1998. Money, Banking, and International Trade. 7 th Edition, Konark,
Delhi.
6. Jhingan, M.L. 2007. International Economics, 5th Edition, Vrinda, India
7. Manur, H.G.1983. International Economics. 2nd Edition, Vikas, Delhi.
8. Salvatore Dominidik.2001.International Economics, 7th Edition, John Willy & Sons,
New York.
9. WTO. 2013. Report on Factors shaping the future of world trade.
Page 53

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Agribusiness Management: International Trade and Finance

INTERNATIONAL TRADE AND FINANCE (ABVM 1042)

HUSSIEN MOHAMMED (MA, Economics)

Revised by:- Hiwot Mekonnen (MSc)

3.2. LEARNING TASK II....................................................................................................3

3.2. LEARNING TASK II

3.2.2. LEARNING TASK OBJECTIVE

At the end of this learning task, students will be able to:

 explore the subject matter of international trade;

3.2.3.1. SECTION ONE: CONCEPTS OF INTERNATIONAL TRADE

Definition of International Trade

Trade is the exchange of goods and services among individuals. Therefore:

 International trade is a business transaction between citizens of different nations and

Inter -regional VS International Trade

Difference between Inter-Regional and International Trade

Problem of Balance of Payments: The problem of balance of payments is perpetual in

Similarities between Inter-Regional and International Trade

separate model for international trade.

In addition, in both international and inter- regional trade:

Commonly used terminologies in international trade

Reasons for international trade and its significance

3.2.3.2. SECTION TWO: CLASSICAL AND NEO-CLASSICAL

The Mercantilists Trade Theory

Theories of Absolute and Comparative Advantage

Theory of Absolute Advantage

Assumptions of the theory of absolute advantage

a) Labor is the only factor of production and is homogenous,

Illustration of absolute advantage

Table 2.1: Absolute advantage

Output of one Man-hour

Fig 2.1 the Theory of Absolute Advantage

Table 2.2: Pre trade production and consumption

Commodity Country A Country B World

Table 2.2: production after specialization and gain from trade

Criticism on theory of absolute advantage

Theory of Comparative Advantage

Assumptions of the theory of comparative advantage

Illustration of comparative advantage

Table 2.3: Ricardo’s comparative cost

Country Wine Cloth

Fig 2.2 Theory of Comparative Advantage

Gains from Trade and Their Distribution

Table 2.4: Exchange rate before trade

Fig 2.3. Theory of comparative advantage

Criticisms on the comparative cost advantage theory

Comparative Advantage and Opportunity Costs

production of a commodity has a comparative advantage in that commodity (and a compar-

The Gains from Exchange and Specialization

Figure 2.4 Gains from Exchange and Specialization

If subsequently country I also specialized in the production of X and produced at point B, it

Offer Curve and Terms of Trade

The Offer Curves of a Nation

Derivation of Offer Curve

Figure 2.5 Offer curve for country I

Figure 2.6 Offer curve for country II

The Equilibrium Relative Commodity Price with Trade

Figure 2.7 Equilibrium Relative Commodity Price with Trade

Change In Terms Of Trade

Figure 2.8 Shift in offer curve

Similarly, an increase in country II's desire for imports of commodity X, an improvement in

Heckscher-Ohlin Theory of Trade

The Heckscher-Ohlin theory is based on the following assumptions:

modity X is L intensive in Country 1. If Country 2, K/L is 4 for Y and 1 for X. Therefore, Y is

Factor abundance: There are two ways to define factor abundance.