INTERNATIONAL TRADE

 focuses primarily in the real transactions in the

international economy , that is, on those transactions
that involve a physical movement of goods or a
tangible commitment of economic resources.
 The Basis for Trade: Specialization
A. The Principle of Absolute Advantage (by Adam Smith)
“When one nation is more efficient than (or has absolute advantage
over) another in the production of one commodity but is less
efficient than (or has absolute disadvantage with respect to) the
other nation 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”
UNITED
Commodity / Country PHILIPPINES
STATES
Wheat (bushels/man-
6 1
hour)
Rice (kg/ man-hour) 4 5
US is more efficient or has absolute advantage in the
production of wheat over the Philippines while it is less
efficient (or has absolute disadvantage) in rice production.
Therefore, it has to specialize in the production of wheat and
export part of it to the Philippines in exchange for rice.

Philippines is more efficient and has absolute advantage in

rice over the US but is less efficient (or has absolute
disadvantage) in wheat production. This implies that the
Philippine has to specialize in the production of rice and
export part of it to US in exchange for wheat.
B. The Law of Comparative Advantage (David Ricardo)
According to Ricardo, even if one nation is less efficient than
(or has absolute disadvantage with respect to) the other nation
in the production of both commodities, there is still a basis for
mutually advantageous trade.
The first nation should specialize in the production of and
export the commodity in which its absolute disadvantage is
smallest (this is the commodity of its comparative advantage)
and import the commodity in which its absolute disadvantage
is greatest (this the commodity of its comparative
disadvantage)
Commodity/country UNITED STATES PHILIPPINES
Wheat
6 1
(bushel/man-hour)
Rice (kg/man-hour) 4 2
the US absolute advantage is greater in wheat and so it has
comparative advantage in wheat.

The Philippines’ absolute disadvantage is smaller in rice so, it

has a comparative advantage in rice.

According to the Law of Comparative Advantage, both nations

can gain if the US specializes in the production of wheat and
exports some of it to the Philippines.

Note that in a two-nation, two-commodity world, once it is

determined that one nation has comparative advantage in one
commodity, the other nation necessarily has the comparative
advantage in the other commodity.
 Neo – classical Theory of Trade (The Opportunity
Cost Theory (Haberler, 1936)
“A country has comparative advantage in producing a good if
the opportunity cost of producing that good in terms of the other
good is lower in that country than it is in the other countries”

Commodity/country UNITED STATES PHILIPPINES

Wheat (bushel/man-
6 1
hour)
Rice (kg/man-hour) 4 2

the opportunity cost of wheat is 2/3 of a unit of rice in US (i.e.

1W=2/3R) while in the Philippines, the opportunity cost of
wheat is (2R/1W) or 2kg of rice/bushel of wheat
 the opportunity cost of wheat production is lower in the US
than in the Philippines so, the US would have a comparative
cost advantage over the Philippines in wheat

the opportunity cost of rice in the Philippines is ½ for 0.5 of a

unit of wheat (i.e. 1R=0.5W) while in US, the opportunity cost
of rice is 6W/4R or 1.5, therefore, the Philippines has
comparative advantage in rice.

Modern Theory of Trade (Hecksher – Ohlin Theory)

“A nation will export the commodity whose production requires
the intensive use of the nation’s relatively abundant and cheap
factor and import the commodity whose production requires the
intensive use of the nation’s relatively scarce and expensive
factor ”
 Factor Proportions Theory

“A nation relatively abundant in capital will export the relatively

capital-intensive goods for which domestic production requires
relatively large amounts of its relatively scarce factor, labor”

THE THEORY OF COMMERCIAL POLICY

Tariffs
 are duties/taxes levied on imported goods either as a source of
revenue for the government or to protect the local
industries/sectors against import competition from the rest of
the world.
 Reasons for Imposing Tariffs

As a source of government revenue

Infant industry argument
Employment Argument

Types of Tariffs
Specific tariffs are levied as a fixed charged for each unit of
goods imported regardless of the value (i.e. $3/barrel of oil)

Ad Valorem tariffs are taxes imposed as a fraction of the

value of the imported goods (i.e. 25% of the value of imported
goods).
 THE COSTS AND BENEFITS OF TARIFFS
Consumer Surplus:
 measures the amount a consumer gains from a purchase by
the difference between the price he is willing to pay and what
he actually pays for the product.
 it is the area below the demand curve and above the
equilibrium price.
Producer Surplus
 refers to the gains derived by producer as measured by the
difference between the price he is willing to sell/dispose his
product and the accrual price he receives from the sale.
 is the area above the supply curve and below the equilibrium
price of the product.
 Analysis of a Tariff on Cotton Shirts
PW = $20 P
Cotton shirts
Free trade:
buyers demand 80
sellers supply 25 S
imports = 55
T = $10/shirt
price rises to $30
buyers demand 70 $30
sellers supply 40 $20
imports = 30 imports
imports D
Q
25 40 70 80
 Analysis of a Tariff on Cotton Shirts
Free trade P
Cotton shirts
deadweight
CS = A + B + C 
+ D + E + F loss = D + F
PS = G
S
Total surplus = A + B 
+ C + D + E + F + G
A
Tariff
CS = A + B B
$30
PS = C + G C D E F
$20
Revenue = E G
D
Total surplus = A + B  Q
+ C + E + G 25 40 70 80
 Analysis of a Tariff on Cotton Shirts
D = deadweight loss from  P Cotton shirts
the  deadweight
overproduction  loss = D + F
of shirts
S
F = deadweight loss from 
the under‐
consumption  A
of shirts B
$30
C D E F
$20
G
D
Q
25 40 70 80
Effects on the Domestic Economy (The Importing Country)

A tariff increases the price of the good in the importing country

As a result, the consumer lose in the importing country while
the producers gain since the consumer surplus declines while
the producer surplus increases
The government in the importing country gains revenue from
the imposition of the tariff

Effect on the Foreign Country (The Exporting Country)

If the importing country is a big country such that the volume of

its imports is large enough, there will be a decline in the price
in the exporting country since imports will decrease by so much
causing the demand to decrease.
TABLE 1
If the importing country is small country where the volume of
imports is not big enough to cause a decrease in the exporting
country, then there will be a very small effect or none at all (i.e.
very insignificant) on the price in the exporting country.
What are the two efficiency losses to the nation’s
welfare of a tariff?
1. Production distortion loss – results from the fact that the
tariff leads to domestic producers to produce too much of a
good which can be purchased more cheaply abroad.

2. Consumption distortion loss – results from the fact that a

tariff leads consumers to consume too little of the good due to
high domestic prices.

What are the perceived/expected benefits from a tariff?

The offsetting gains of a tariff are represented by the government 
revenue derived and the terms of trade gains that arise because a 
tariff lowers the foreign export prices. 
these gains depend on the ability of the tariff‐imposing country to 
effectively use the revenue and to drive the down foreign export 
prices
 In a small country case, a tariff imposed cannot significantly affect 
foreign export prices, thus, the terms of trade gains drop out, so 
that the costs of the tariff unambiguously exceed its benefits.

What about tariff reduction?

Tariff reduction in agricultural products is one of the commitments 
under the Final Act of the UR. That is:

for industrialized countries, tariffs must be reduced by 36%

within six (6) years from the year of GATT implementation
for developing countries, tariff reduction should be 24% within
ten (10) years and
for least developed countries, they are exempted from tariff
reduction
What are the expected effects of tariff reduction?

The domestic price in the importing country declines and

approach the world price
There is a transfer of gains from producers back to consumers
Producer surplus or welfare gains of producers decline due to
lower prices
Welfare gains of consumers increase due to lower prices
allowing more demand and consumption
Tariff reduction eliminates production distortion losses
because there will be more efficient utilization or resources as
these will be redistributed according to the dictates of
comparative advantage
Reduction in tariffs also eliminates the consumption distortion
losses because consumers can now enjoy more goods at
lower prices.
 Non – Tariff Barriers to Trade
a) Import quota which limits the quantity of imports to some
specified level that is less than free trade quantity.
b) Limiting the amount of foreign exchange made available to
do importation of the good
c) Import ceiling is very similar to import quota. The government
may impose ceiling or maximum amount that an importer can buy
from the rest of the world.
d) International standards may be another way by which a
particular country can restrict importation from other countries.
Examples of these kinds include: ISO, HACCP, etc.

e) Sanitary and phyto – sanitary measures. This has something

to do with the country’s prerogative to protect human, animal and
plant life and health as well as the environment.
The Foreign Exchange and Foreign Exchange Market
Foreign Exchange
 refers to the currency of the rest of the world rather than
one’s own currency
FOREIGN EXCHANGE MARKET
New York Foreign Exchange Market
London
Paris, Montreal
Tokyo and many others
Major Players in Foreign Exchange Market
Commercial banks play a major role in international transactions.
Corporations that are engaged in international trade and with 
operations in several countries also receive and accept payments in 
foreign currencies.
 Non‐bank institutions like asset‐management firms and insurance 
companies
Central banks

Functions of the Foreign Exchange Market

a) International clearing
 The foreign exchange market provides services to its clients in 
terms of converting one’s currency to another to pay 
international obligations.
b) Hedging
 has something to do with the avoidance of foreign exchange 
risks. It is a means of protecting oneself against foreign 
exchange fluctuations.
c) Speculation
 is a process by which foreign exchange players/dealers engage in 
the buying and selling of foreign currencies for the purpose of 
gaining profits.
 Instruments of Foreign Exchange
Cable or telegraphic transfers. 
 An importer in the Philippines with a payment to make abroad 
would pay in pesos to the Philippine bank, which would cable its 
branch or its foreign correspondent to make the payment in 
foreign currency to the exporter abroad
Bank Drafts
 These are simply checks drawn by one bank on another, 
sometimes used instead of telegraphic transfers.

Letter of Credit (LC)
 This may be denominated and make payable in the currency 
either of the exporter or importer.
 The Exchange Rate Systems
1) Flexible ER is solely determined by the forces of supply and
demand for the foreign currency (i.e. US $)
2) Fixed/Pegged ER is a rate which is controlled by the Central
Bank (CB)
Changes in Exchange Rates
1) Changes in the supply and 
demand conditions for US dollars.

Depreciation occurs 
when there is a fall in 
the value of the Peso 
relative to the US dollar
 Appreciation occurs 
when the value of 
the Peso increases 
relative the US dollar

2) Central Banks’s action through
devaluation or revaluation
Devaluation is a Central Bank’s action to reduce the value of the Peso 
against the dollar. This occurs when the CB’s official reserves are not 
enough to support the exchange rate pegged at a certain level.
Revaluation is also a Central Bank’s action that increases the value of 
the peso against the dollar. When there is excess supply of dollars in 
the economy, the CB has to buy the excess dollars so that the 
exchange rate is maintained at a certain desired level.  
Effects of Devaluation/Depreciation on Imports and Exports
Both will result to a decrease in the value of the Peso relative to the 
US$. This means that, it is now more expensive to buy the same one 
dollar worth of goods before the devaluation or depreciation 
occurred
 Importations were discouraged, imports will decrease
An opposite effect on exports will happen. The foreigners will need 
less amount of dollars to buy the same amount quantity of goods 
before the devaluation/depreciation occurred. 
Exports therefore will be encouraged , exports will increase

Effects of Devaluation/Depreciation on the

Balance of Payments

Since export earnings will increase due to increased

exports and import expenditures will decrease because there
will be less importations, then the balance of payment will be
improved eventually
 The Balance of Payment (BOP)
 is the country’s record of all transactions between its
residents and the residents of the rest of the world. In the
other words, the BOP records all the payments made by
domestic citizens to foreigners.
The BOP account of a particular country is broken down into:
1. The Current Account
It includes the following components:
Exports and imports of goods
Export and imports of services
Investment income
Net Transfers
2. Capital Account
3. Official Reserves Transactions Account
 BOP Deficit/Surplus

a) BOP deficit
 occurs when the nation’s payments to the foreigners exceed
the receipts from them. This means that the domestic
economy is borrowing or accumulating debts from abroad.

b) BOP surplus
 occurs when the nation’s receipts from the rest of the world
exceed the payments made to them. This means that there
is growing domestic claims on foreign wealth. In other
words, the foreigners are accumulating debts/loans from the
domestic economy.
Problems with Excessive BOP Deficits/Surplus

Why is an excessive BOP deficit a problem to the government?

If the projects that the draw on foreign funds are not well 
planned, it could not generate the profits as expected to repay 
the loan;
Due to large BOP deficits, foreign creditors may become 
reluctant to extend new loans to a particular country and may 
even demand immediate repayment of the previous loans;
This then will lead to the “loss of foreign investors’ confidence” 
which could further worsen the problem.
Why is BOP Surplus still a problem to a particular country?

For a given level of domestic savings, an increase in foreign 
investment means lower domestic investments in plant and 
equipment;
This implies lower capital stock accumulation in the domestic 
economy and therefore lower productive capacity;
This leads to worsening unemployment problems and lower 
national income;
Countries with large BOP surplus may also become the targets 
of discriminatory protectionist measures by the trading 
partners with external deficits. 
 TRADE RELATED ISSUES
GATT – UR – WTO
 GATT stands for the General Agreement on Tariffs and
Trade.
 It was formed in 1947 in Geneva initially with 23 countries in
attendance to promote multilateral cooperation in trade and
investments.
 Seven more rounds of meetings have taken place since
1947 until finally the Uruguay Round of Multilateral Trade
Negotiations was launched in September 1986 at Punta del
Este, Uruguay.
 After eight years of negotiations, the final agreements were
reached resulting to the signing of the Final Act of the
Uruguay Round on April 15, 1994 in Marrakesh, Morocco by
111 countries (90% of world trade members).
  It generally calls for a more liberalized trade, which is a
paradigm shift from past practices of restricted trade and
protectionism.

The economic framework , which has been formally defined

by GATT – WTO calls for the expansion and stabilization of world
trade through the following:
1. Tariffication of quantitative restrictions (QRs)
2. Reduction of tariffs on all agricultural products
3. Reduction of domestic price subsidies
4. Reduction of Export subsidies
5. Market access commitments, and
6. Harmonization of sanitary and phyto – sanitary measures
What is Uruguay Round (UR)?

 is the eight most ambitious rounds of GATT negotiations. It

seeks to expand world trade based on comparative
advantage in four ways:
1. Wider and deeper tariff cuts
2. A strong and more effective GATT
3. Eliminating exceptions to GATT’s universal coverage of goods
4. Expanding coverage to make more relevant to the global
trading environment
What in general does the UR accomplish for world trade?
In the simplest terms, the UR clears the way for freer trade
among nations in three ways:
Reducing the barriers to trade in goods and services so that
countries can freely gain access to each other’s markets.
Clear and stable rules so that the way world trade is carried
out become transparent and predictable.
Formation of world trade organization with stronger powers
to police world trade and settle disputes and where issues
can be discussed.
What are the provisions of the Agreement on Agriculture?
Conversion of all quotas and other quantitative restrictions (QRs) into 
tariffs, a process called “tariffication” in GATT parlance.
Tariff cuts
Reduction of domestic subsidies
Reduction of export subsidies
Harmonization of sanitary and phyto – sanitary measures (SPS)
Continuation of the reform process
 What is WTO?
stands for World Trade Organization. It is a permanent
institution to replace GATT which has existed on a provisional
basis.
It has an effective capacity and stronger powers to enforce
GATT rules and discipline among member – countries.
Specifically, it provides trade negotiations and settlement of
trade disputes among contracting countries and it also
provides for trade policy review mechanism and global policy
coherence.

Results of GATT – UR – WTO

1. Liberalized trade
2. Administrative reforms QUESTI
ONS