Agr

ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

CHAPTERONE:CONCEPTSOFI
NTERNATI
ONALTRADE

Ethi
opi
aexpor tsdi
ffer
entgoodsandservicesespecial
l
yagri
cul
tur
alcommodit
iesandi mport
capi
talgoodsf ori
ndustri
ali
zat
ionendeavor.Thetradepart
nerswit
hEthi
opiaarecount r
ies
fr
om Asia,Afr
icaSouthandNorthAmerica,andEurope.Whatdoyouknowaboutint
ernati
onal
tr
adeandi t
simportancefornat
ions?

1.
1.Def
ini
ti
onofI
nter
nat
ional
Trade

Int
ernati
onaltradedeal swiththepur et heor
yoft rade, t
het heoryofcommer cialpoli
cy,foreign
exchangemar ketsandt hebalanceofpay ment s,andadj ustmenti nt hebalanceofpay ment s.
Thepur et heoryoft radeanal yzest hebasi sf orandt hegai nsf rom t r
ade.Thet heoryof
commer cialpolicyexami nest her easonsf orandt heef f
ect softr ader estric¬ti
ons.For eign
exchangemar ketsaret heframewor kf ortheex changeofonenat ionalcur rencyf oranot her,
whil
et hebalanceofpay ment smeasur esanat ion'st otalreceiptsfrom t het otalpayment st o
therestoft hewor l
d.Fi ¬nal
ly,adjustmenti nthebal anceofpay ment sisconcer nedwi tht he
mech¬anismsf orcorrectingbal ance- ofpay ment sdi sequi l
ibri
a( i
.e.,def i
citsandsur pluses)
underdif
ferentinter
nationalmonet arysy st
emsandt heireffectonanat ion'
swel fare.

1.
2. Feat
uresofI
nter
-r
egi
onal
andI
nter
nat
ional
Trade

I
nter-
regi
onalt
raderefer
st otr
adebet weenregi
onswit
hinacountr
y.Thusi
nter
-r
egi
onalt
rade
i
sdomest icorinter
naltrade.Int
ernati
onaltr
ade,ontheotherhand,i
str
adebetweent wo
nati
onsorcountr
ies.

1.
3.Di
ff
erencebet
weenI
nter
-Regi
onalandI
nter
nat
ional
Trade

Fact
orI
mmobi
l
ity:f
act
orsofpr
oduct
ionar
efr
eel
ymobi
l
ewi
thi
neachr
egi
onasbet
ween
pl
acesandoccupat
ionsandi
mmobi
l
ebet
weencount
ri
esent
eri
ngi
ntoi
nter
nat
ional
trade.

Di
ff
erencesi
nNat
uralResour
ces:Di
ff
erentcount
ri
esar
eendowedwi
thdi
ff
erentt
ypesof
natur
alresources.Hencetheytendtospeciali
zeinproducti
onofthosecommodi t
iesinwhich
theyarerichl
yendowedandt r
adethem withot herswheresuchresour
cesarescarce.Those
countri
escant r
adeeachot her
'scommodi t
iesont hebasesofcomparati
vecostdi
ffer
encesin
theproducti
onofdiffer
entcommodi t
ies.

Geogr
aphi
calandCl
i
mat
icDi
ff
erences:Ever
ycount
rycan’
tpr
oduceal
lthecommodi
ti
esduet
o
geogr
aphi
cal
andcl
i
mat
iccondi
ti
ons,
exceptatpossi
blypr
ohi
bit
ivecost
s.

Di
ff
erentMar
ket
s:I
nter
nat
ionalmar
ket
sar
esepar
atedbydi
ff
erencei
nlanguages,usages,
habi
ts,
tast
es,
fashi
onset
c.Ev
ent
hesy
stemsofwei
ght
sandmeasur
esandpat
ter
nandst
yles
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page1
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

i
nmachi
ner
yandequi
pmentdi
ff
erf
rom count
ryt
ocount
ry.

Mobi
l
ityofGoods:Themobi
l
ityofgoodswi
thi
nacount
ryi
srest
ri
ctedbyonl
ygeogr
aphi
cal
di
stances and t
ranspor
tat
ion cost
s.Butt
her
e ar
e manyt
ari
ffand non t
ari
ffbar
ri
eron
mov ementofgoodsbetweencountr
ies.

Dif
ferencecur
rencies:Thepri
nci
paldi
ffer
encesbetweeni
nter
-r
egi
onalandint
ernati
onalt
rade
l
iesinuseofdiff
erentcurr
enci
esinfor
eigntr
ade,butt
hesamecurr
encyindomestictr
ade.

Pr
obl
em ofBal
anceofPayment
s:Thepr
obl
em ofbal
anceofpay
ment
sisper
pet
uali
n
i
nter
nat
iona1t
radewhil
eregi
onswithi
nacountr
yhavenosuchprobl
em.Thi
sisbecauset
her
e
i
sgreat
ermobil
it
yofcapit
alwi
thi
nregi
onsthanbet
weencount
ri
es.

Di
ff
erentTr
anspor
tCost
s:Tr
adebet
weencount
ri
es’i
nvol
veshi
ght
ranspor
tcost
sasagai
nst
i
nter-
regional
l
y wi
thi
n a count
ry because ofgeogr
aphi
caldi
stances bet
ween di
ff
erent
countr
ies.

Di
ff
erentEconomi
cEnvi
ronment
:Count
ri
esdi
ff
eri
nthei
reconomi
cenv
ironmentwhi
chaf
fect
s
thei
rtraderel
ati
ons.Thel
egalfr
amewor k,
insti
tuti
onalset
-up,
monet
ary,
f i
scalandcommerci
al
poli
cies,f
actorendowments,product
iontechniques,nat
ureofpr
oducts,etc.di
ff
erbet
ween
countri
es.

Di
ff
erentNat
ionalPol
i
cies:Anot
herdi
ff
erencebet
weeni
nter
-r
egi
onalandi
nter
nat
ionalt
rade
ar
isesf
rom t
hefactt
hatpol
ici
esrel
ati
ngtocommer
ce,
trade,
taxat
ion,
etc.ar
ethesamewi
thi
n
acount
rybutdi
ff
erfr
om onecountr
ytoanother
.

1.
4.Reasonsf
ori
nter
nat
ional
tradeandi
tssi
gni
fi
cance

Ingeneral,t
heimmediat
ecausefortradeamongnat ionsi
sdi f
ferenceinthepri
cesofgoods
andservicesamongnations.Nat
ionsdif
ferinr esour
ceendowment s,t
heleveloft
echnol
ogy
andtechnicalski
l
lsorknowhow.Mor eover,naturehasdist
ri
but edresour
cesunevenl
yinthe
worl
dwhi chmakesproducti
onofsomegoodsi nsomecountriesimpossibl
e.

Thus,i
nter
nati
onalt
radehasenabl
edthewor
ldnat
iont
oconsumet
hosegoodsandser
vices
whicht
heythemselv
escouldnotpr
oduce.

CHAPTERTWO:CLASSI
CALANDNEO-
CLASSI
CALTHEORI
ESOFI
NTERNATI
ONALTRADE

Nat
ionsi
nvol
veinint
ernat
ionaltr
adethr
oughexpor
tingandimport
inggoodsandser
vices.
Whatdoyout
hinkt
hebasisforandgai
nfr
om i
nter
nat
ionalt
radeamongnat
ions?
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page2
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

2.
1.TheMer
cant
il
ist
sTr
adeTheor
y

Mercant
ili
sm iseconomi cnati
onal
ism whichwasadvocat
edinthe16thcent
uryfort
hepur pose
ofbuil
dingaweal thyandpower f
ulstate.Adam Smit
hinhisbook“ TheWeal thofNat i
ons”
coi
nedthet er
m" mer canti
l
esy st
em"todescr i
bethesyst
em ofpoli
ti
caleconomyt hatsought
toenri
cht hecount r
ybyr est
rai
ningimportsandencouragi
ngexpor t
s.Inotherwor ds,the
mercanti
li
stsmaintainedthatthewayf oranati
ontobecomerichandpower f
ulwast oexport
morethanitimported.

Inanyev ent
,mercanti
li
stsadvocatedstri
ctgov
ernmentcont
rolofal
leconomi
cacti
vit
yand
preachedeconomicnational
ism becauset
heybe¬l
iev
edthatanati
oncoul
dgainint
radeonl
y
attheexpenseofothernati
ons.

Adam Smi thledanel oquentandv i

gor ousattackuponmer cantil
i
stt heoriesofint
ernational
tradeinhisbook“ Weal t
hofNat ions”publ i
shedi n1776.Smi t
harguedt hatitwasabsur dt o
manuf act
ureacommodi tyinacount r
yatagr eatexpensei fasi mil
arcommodi tycouldbe
suppli
edfrom foreigncountri
esatal owercost.He, thus,
opposedt hei mposi t
ionoftari
ffson
thegoodsi mpor ted fr
om ot hercount ri
es,and r ecommended t hatt radeamong di fferent
countri
esshoul dbef r
eeandbebasedon' terr
it
or i
aldivi
sionofl abor'.Headv ocated,t he
doctri
nesoflaissez-f
air
e,orfreemar kets,i
nter
pretedaseconomi cwelfareinaf arwidersense
ofencompassi ngtheent i
repopul
ation.

2.
2.Theor
iesofAbsol
uteandCompar
ati
veAdv
ant
age
Theor
yofAbsolut
eAdv ant
age

Adam smi th( 1723-

1790)provi
ded thebasicbuildi
ng bl
ocksfort heconstr
ucti
on oft he
classi
caltheoryofinter
nat
ionaltr
ade.Heenunciatedthetheor
yi ntermsofwhati scalled
AbsoluteAdv ant
agemodel.Adam Smi t
hviewedthatfort
wonationstot r
adewit
heachot her
voluntar
il
y,bothnati
onsmustgain.Ifonenati
ongainednot
hingorlost,
itwoul
dsimplyref
use
totrade.

Accordingt oAdam Smith,tr

adebet weentwonati
onsi sbasedonabsol uteadvantage.When
onenat i
oni smoreeff
ici
entthan(orhasanabsoluteadvantageover)anotherint
hepr oduct
ion
ofonecommodi tybutislesseffi
cientt
han(orhasanabsol ut
edisadvantagewithrespectto)
theothernat i
oninproducingasecondcommodi t
y,thenbothnationsthroughtradecangai n
byeachspeci al
izi
ng inthepr oducti
onoft hecommodi t
yofi tsabsol uteadvantageand
exchanging partofits outputwi ththe ot
hernation forthe commodi t
yofi ts absol
ute
disadvantage.

Assumpt
ionsoft
het
heor
yofabsol
uteadv
ant
age

a)Labori
stheonl
yfact
orofpr
oduct
ionandi
shomogenous,
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page3
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

b)Laborwascompl etel
yfreet omov ewit
hinasi ngl
ecountry,yeti
twasent i
rel
yimmobi l
e
i
nternat
ionally
.I fl
aborwer efreetomovebet weennat
ions,t
hendifferencesinwager at
es
andhencecommodi t
ypricescouldbeequal i
zedvial
abormi grat
ion,andtherewoul dbe
noneedf orinternati
onaltrade,
c)Bot hcountriescanpr oducebot hcommodities,
d)Not ranspor t
ationcostswer einvol
vedi
nt r
ade
e)Ther eexistednoot herbarrier
s,suchastari
ffsandquotas,
totradebet weencountr
ies.
f) Constantreturnstoscale,

I
ll
ust
rat
ionofabsol
uteadv
ant
age

Imagi
neahy potheticalwor l
dcomposedofonl ytwocount r
ies,countr
yAandcount ryB.Bot h
countr
iesproducesi gnif
icantquant it
iesofwheatandoi lfordomest i
cconsumpt i
on,
andt here
areabsolut
elynot raderel at
ions,fact
ormov ements,orothereconomi ctiesbetweenthem; i
.e.
,
eachistakent obeoper ati
ngi nast ateofi sol
ation(aut
arky).Assumef orthemomental so
thatt
heent i
rev alueoft het wocommodi t
iesistheamountofl aborusedi nt hei
rproducti
on.
Now suppose,f urther,thatoneman- hourofl aborcanpr oducet hef oll
owingquant i
ti
esof
wheatandoi li
nt het worespect i
vecount r
ies:

Tabl
e2.
1:Absol
uteadv
ant
age

Out
putofoneMan-
hour

Commodi
ty
Count
ryA Count
ryB

Wheat(
Qui
ntal
s) 5 10

Oi
l(bar
rel
s) 10 5

Table2. 1andFigur
e2.1reveal
sthatcountr
yAcoul dproduce10barrelofoi
landnowheat,5
quintalofwheatandnooil
,orsomecombi nati
onofwheatandoilbet
weent hesetwoext
remes
withonemanhourofl abor.Thedif
ferentcombinati
onsthatcountryA couldpr
oduceare
represented bytheli
neGG’i nt heFigure2.1 below.Thisisreferr
ed to ascount
ryA’s
productionpossi
bil
i
tyf
ronti
er.

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page4
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Fi
g2.
1TheTheor
yofAbsol
uteAdv
ant
age

Simil
arl
y,countr
yBcouldproduce5barr
elofoi
landnori
ce,10qui nt
alofwheatandnooil
,or
somecombi nat
ionbet
weent heset
woext r
emes.Thedif
ferentcombinati
onswheatandoil
avai
labl
et ocountr
yBrepr
esentedbytheli
neKK’i
nthef
igure,whichiscountr
yB’
sproduct
ion
possibi
l
ityfr
onti
er.

Inthi
scase,aqui ntalofwheati ncountr
yAhast wi
cethev al
ueofabar relofoilandabar
relof
oil
incountryBhast wicethev al
ueofaquintal
ofwheat.Apparent
ly,
count r
yAhasanabsol ute
advantageint heproduct i
onofoi l(10bar
relisgr
eaterthan5bar r
el),andcount ryBhasan
absoluteadvantageint heproducti
onofwheat(10qui
ntalisgreat
erthan5qui ntal
).

Toseethebenef
itf
rom anint
ernat
ionalt
rade,i
tisbet
tert
obeginfr
om autar
ky.Astable2.
2
showst
hecombinat
ionofbothgoodsproducedandconsumedbyeachcountr
ybefor
etrade.

Tabl
e2.
2:Pr
etr
adepr
oduct
ionandconsumpt
ion

Commodi
ty Count
ryA Count
ryB Wor
ld

Wheat(
Qui
ntal
s) 5 10 15

Oi
l(bar
rel
s) 10 5 15

Whenbot hcountri
esproducewheatandoilf
ordomest
icconsumpt
ion,andabsol
utel
yno
t
raderelat
ionsexistbetweent
wocountr
ies,t
heworl
dproduct
ionwouldbe15quintal
sof
wheatand15barrelsofoil
.

I
fthet
wo countr
iesopened thei
reconomy,thedi
rect
ion t
hattradewoul
dt akecan be
i
mmedi
atel
ydet
ermined.Ther
efor
e,count
ryAwoul
dexportoi
ltocountr
yB,
inr
eturnforwhi
ch
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page5
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

count
ryB wouldexportwheattocount
ryA.I nthi
scaset her
ei sascopeforcompl
ete
speci
ali
zat
ioni
nproducti
oninbot
hcountr
ies.Theeff
ectofopeningt
radebet
weenthet
wo
count
ri
esisshowni
nthef ol
l
owi
ngtabl
e.

Thetablebelowr evealsthatbeforetradebothcount
riesproduceonly15uni tseachofthetwo
commodi t
iesbyappl y
ing one labor-uni
ton each commodi ty.IfA wer et o speci
ali
ze i
n
produci
nginoilpr oducti
onandusebot hunit
soflaboronit,i
tstotalproductionwillbe20unit
s
ofoil
.Si
mi l
arly
,ifBwer et ospecial
izeintheproduct
ionofwheatal one,it
st otalpr
oducti
onwill
be20uni t
sofwheat .Thecombi nedgai ntobothcountr
iesfrom t
radewi llbe5uni tsofoi
land
5unitofwheatf orcountryAandB, r
espectiv
ely.

Tabl
e2.
2:pr
oduct
ionaf
terspeci
ali
zat
ionandgai
nfr
om t
rade

Pr
oduct
ion Pr
oduct
ion
Gai
nfr
om t
rade
bef
oret
rade Af
tert
rade
Commodi
ty
Count
ry Count
ry Count
ry Count
ry Count
ry Count
ry

A B A B A B

Wheat(
Qui
ntal
s) 5 10 - 20 -
5 +10

AOil
sar(
ba
esrr
e
ul
l
ts
o)
ftr
ade,thet1
o0
t
alproduct
i5
onofthetw20 ount
oc ri -entup.T
esw +
h1
i0
smeanst-
h5
atbot
h
countr
iesbecomer i
cherorhav ebecomebet t
eroffintermsofproducti
on,af
tert
radeas
compar edtobefor
etrade,
withoutmakinganycountr
yworseof
f.

Cr
it
ici
sm ont
heor
yofabsol
uteadv
ant
age

Smi t
hhasbeencr i
tici
zedf orhisv aguenessandl ackofcl ar
ity
.Accor di
ngly,Smit
hassumes
withoutargumentthatint
ernationaltraderequi
resanexpor t
ingcountrytohav esuperi
orit
ywith
agi v
enamountofcapi t
alandl abortopr oducealargeroutputthananyr iv
al.Butthisbasisof
tr
adei snotreali
sti
cbecauset her
ear emanyunder developedcount r
ieswhichdonotpossess
absoluteadvantageinthepr oducti
onofanycommodi t
y,andy ettheyhavetraderelat
ionswith
othercountri
es.Thus,Smith'sanalysisisweakandunr eali
sti
c.

2.
3.Theor
yofCompar
ati
veAdv
ant
age

Li
keAdam Smit
h,Davi
dRi
car
doemphasi zedthesuppl
ysideofthemarket
.Theimmediat
e
basi
sfort
radestemmedf
rom costdi
ff
erencesbetweennati
ons,whi
chwereunder
li
nedby

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page6
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

theirnat
uralandacquiredadvant
ages.Unl
ikeAdam Smit
h,whoemphasizedthei
mportanceof
absolute costdif
ferences among nati
ons,David Ri
cardo emphasi
zed compar
ati
ve cost
diff
erences.

Compar at
iveAdvantagei
sasituat
ioni
nwhichonecountryspeci
ali
zeinpr
oducingthegoodsit
producesmostef f
ici
ent
lyand buyst hepr
oductsitproducesl essef
fi
cientl
yf r
om other
countri
es,eveni
fitcoul
dproducethegoodsmoreeff
ici
entl
yit
sel
f.

Assumpt
ionsoft
het
heor
yofcompar
ati
veadv
ant
age

 The wor ld consi sts oft wo nat i

ons,each usi ng a si ngl ei nputt o pr oduce t wo
commodi ti
es.
 Ineachnat ion,l abori st heonl yinput.Eachnat ionhasaf i
xedendowmentofl abor,
whichisf ull
yempl oy edandhomogeneous.
 Laboriscompl etelyf reetomov ewi t
hinasi nglecount ryamongi ndust ri
es,yetisent ir
ely
i
mmobi l
ei nternat i
onal l
y.
 Nationsmayusedi fferentt echnol ogies,butal lf i
rmswi thin each nation utili
zea
commonpr oduct ionmet hodort echnologyf oreachcommodi ty.
 Costsdonotv arywi thint hel evelofpr oduct i
onandar epr opor t
ionaltotheamountof
l
aborused.
 Therearesi mi lartestbet weencount r
ies.
 Perfectcompet i
t i
onpr evailsi nal lmar kets.Becausei tisassumest hatno si ngle
producerorconsumeri sl argeenought oi nfl
uencet hemar ket,allarepr icet akers.
Productqual itydoesnotv ar yamongnat i
ons, i
mpl yingt hatal lunitsofeachpr oductar e
i
dent i
cal.Ther eisf reeent r
yt oandexi tfrom ani ndust ry,andt hepr i
ceofeachpr oduct
equalsthepr oduct sofmar ginal costsofpr oduction.
 Freetradeoccur sbet weennat i
ons( i.
e.;nogov ernmentbar r
ierst otradeexist).
 Transactioncost sar ezer o.Consumer swi l
lthusbei ndiff
er entbet weendomest i
cally
producedandi mpor tedv ersionsofapr oductifthedomest i
cpr i
cesoft het wopr oduct s
areidentical.
 Fir
ms make pr oduct ion deci sions in an at t
emptt o maxi mi ze profi
ts,wher e as
consumer smaxi mi zesat isfactionthrought heirconsumpt i
ondeci sions.
 Tradei sbal anced;expor tsmustpayf ori mpor ts,thusr uli
ng outf lowsofmoney
betweennat i
ons.

Il
lust
rati
onofcompar at
iveadvant
age
Inhisexampl eRicardoimaginedtwocount ri
es,EnglandandPortugal,pr
oduci
ngtwogoods,
clot
handwi ne,usinglaborasthesol einputinproduct i
on.I
nst
eadofassumi ng,asAdam
Smithdi d,thatEnglandismor epr oducti
veinpr oducingonegoodandPor tugali
smore
producti
veint heother;Ri
cardoassumedt hatPor t
ugalwasmor epr oducti
vei
nbothgoods.
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page7
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

BasedonSmi t
h'si
ntui
ti
on,t
hen,i
twoul
dseem t
hatt
radecoul
dnotbeadv
ant
ageous,atl
east
forEngl
and.

Ricardoshowedt hatthespeciali
zati
ongoodi neachcountryshouldbet hatgoodi nwhichthe
country had a compar at
ive adv ant
age i n pr oduct
ion.In ordert oi denti
fy a country'
s
compar at
ive advant
age,itr equir
es a compar i
son ofproducti
on cost s across countr
ies.
Howev er,onedoesnotcompar ethemonet arycostsoreventher esourcecosts( l
aborneeded
peruni tofout put)ofpr oducti
on.I nstead one mustcompar et he opportuni
tycosts of
producinggoodsacrosscount ri
es.Thisisillustr
atedinter
msofRi cardo’swellknownexampl e
oftradebetweenEnglandandPor t
ugal asshowni nTable2.3.

Tabl
e2.
3:Ri
car
do’
scompar
ati
vecost

Count
ry Wi
ne Cl
oth

Engl
and 120 100

Por
tugal 80 90

Thet abl
eshowst hatt hepr oduct i
onofauni tofwinei nEnglandr equires120menf oray ear
whileaunitofclothr equir
es100menf orthesameper iod.Ont heot herhand,t hepr oduction
ofthesamequant iti
esofwi neandcl othinPor t
ugalrequires80and90menr espectiv
ely.Thus,
Englandusesmor elaborthanPor tugalinproducingbot hwi neandcl oth.Inot herwor ds,the
Portugueselaborismor eefficientthantheEngl i
shl aborinpr oducingbot hthepr oducts.So
Portugalpossessesanabsol ut eadv ant
agei nbothwi neandcl ot
h.Howev er,Portugalwoul d
benefitmorebypr oducingwi neandexpor ti
ngitt oEngl andbecausei tpossessesgr eater
compar at
iveadvantagei nit.Thi sisbecauset hecostofpr oducti
onofwi ne( 80/120men)i s
l
esst hanthecostofpr oductionofcl oth(90/100men) .

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page8
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Fi
g2.
2Theor
yofCompar
ati
veAdv
ant
age

Ont heot
herhand,itisinEngland’
sinter
esttospecial
i
zei nthepr
oduct
ionofclot
hi nwhichit
hast hel
eastcompar at
ivedisadv
antage.Thisisbecauset hecostofclothproducti
onin
Englandi
nl ess(
100/ 90men)ascompar edwit
hwi ne(120/80men).Thus,tr
adeisbenefici
al
forbotht
hecount r
ies.Thecompar ati
veadvant
ageposi t
ionofbothisi
ll
ustr
atedi
nFi g.2.2i
n
ter
msofpr oduct
ionpossibil
i
tycurves.

PList heproductionpossibi
li
tycurveofPor t
ugal,andEGt hatofEngland.Por tugalenjoysan
absoluteadvantagei ntheproducti
onofbot hwineandcl othoverEngland.I tproducesOLof
wineandOPofcl oth,asagainstOGofwi neandOEofcl ot
hproducedbyEngl and.Butthe
sl
opeofER( parallelt
oPL)r eveal
st hatPor
tugalhasagr eatercompar ati
veadv antageinthe
producti
onofwi nebecausei fitgi
vesupt heresourcesrequir
edtoproduceOEofcl oth,i
tcan
produceORofwi newhi chisgreaterthanOGofwi neofEngland.Ont heot herhand,England
hadt heleastcompar ati
vedisadvantageinthepr oduct
ionofOEofcl ot h.Thus,Por t
ugalwil
l
exportORofwi net oEnglandinexchangeforOEofcl othfr
om her.

Gai
nsf
rom Tr
adeandThei
rDi
str
ibut
ion

Theoppor
tunit
yf orgai
ncanbeseeni mmediat
elybycompar i
ngtherealexchangerati
ost
hat
wil
lpr
evai
li
neachcount ryi
ntheabsenceofint
erna¬t
ionalt
rade.I
nPortugal
,ini
solat
ion1uni
t
ofcl
othwi
llexchangefor1.
13barr
elsofwine

Tabl
e2.
4:Exchanger
atebef
oret
rade

Engl
and Por
tugal

Wi
ne120:
100Cl
oth(
1:1.
2) Wi
ne80:
90Cl
oth(
1:0.
89)

Cl
oth100:
120Wi
ne(
1:0.
83) Cl
oth90:
80Wi
ne(
1:1.
13)

Supposenow,asRicardodid,
thatbothcountr
iesareoffer
edt hechancetot r
adeatt
hebart
er
exchangerat
io1clothfor1wi ne.Port
ugalwillf
indsucht radeanat t
racti
vewaytoacqui
re
cl
oth.Inst
eadofgi
vi
ngup1. 13barrel
sofwinet oobtai
n1clot h,
itneedgiveuponl
y1barr
elof
wine.I
tsaves0.
13barrelofwi
neoneachuni tofclot
hacquired.

Consequent l
y,Port
ugalwil
lspeci
ali
zei nwineproduct i
on,andob¬t ai
ni t
sclot
hf r
om England
thr
ought rade.Simil
arl
y,Engl
andwi l
lbenefitbecausef oronecl ot
hitcanobt ainabarrelof
wine,
insteadofonly0.89ofabarrelasindirectproducti
on.Itwil
lspecial
izei
ncloth,
obtai
ning
winefrom Por t
ugalthr
oughtr
adeatl esscostthani tcanbepr oducedathome.ThusRi cardo
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page9
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

showedt
hatbot
hcount
ri
esgai
n,ev
ent
houghPor
tugalenj
oysanabsol
uteadv
ant
agei
nbot
h
commodi
ti
es.

Thegainsfr
om tradeandt hei
rdi stri
¬butionareal
soshowni nFigure2.3wheret helineC1W2
depi
ctsthedomest i
cexchanger atio1uni tofcl
oth=0.83unitofwineofEngland, andtheli
ne
WIC2 t
hatofPor t
ugalatthedomest icexchangerati
o1unitofwi ne=0. 89unitofcl ot
h.The
l
ineC1W1showst heexchangerat eoft r
adeof1unitofclot
h=1uni tofwi nebetweent hetwo
count
ri
es.Atthisexchangerate,Engl andgainsW2W1 (0.
17unit)ofwine,whil
ePor tugalgai
ns
C2C1(
0.11unit
)ofcloth.

Fi
g2.
3.Theor
yofcompar
ati
veadv
ant
age

Att hi
spoint,youmayask,“ How di
dRi car
doknow t hatthebartert
ermsoft r
adebetween
PortugalandEnglandwouldbe1C:1W? ”Theansweri sthathedidnotknow preci
sel
ywhat
thatrat
ewoul dbe.Al
lheknewwast hattheint
ernat
ionalexchangerat
iohadt
oliesomewhere
i
nbe¬t weenthetwodomesticrat
ios,
thatis,

Por
tugal 1C:
1.13W

Engl
and 1C:
0.83W

Anyr ati
obet weentheset woli
mitswill
permitbot hcountr
iestogai nf
rom tr
ade.Ricar
dochose
ther ati
o1C:1W becausei twasaconv enientonet ousei nmakinghi spoint
.Hedi dnot
discusst hef or
cest hatwoulddeterminetheexactr at
iothatwoul dexi
stint hemar ket.He
simplysai dthatthetwocount r
ieswouldgainf rom tr
adesol ongasEngl andconcentrat
edon
thepr oducti
onofcl othandPortugalonthepr oduct
ionofwi ne.Ricar
dodidnotgiveanamet o
thepr i
ncipl
e,butithaslongbeenknownast helawofcompar ati
vecosts.

Cr
it
ici
smsont
hecompar
ati
vecostadv
ant
aget
heor
y

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page10
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

 Themostsev erecr i
ticism oft hecompar at i
v eadv ant agedoct r
inei sthatiti sbasedont he
l
abort heor yofv alue.Undert hel abort heor yofv alue,t hev alueorpr iceofacommodi t
y
depends excl usivelyon t he amountofl abort ime goi ng intot he product ion oft he
commodi ty.Si ncenei theroft heseassumpt ionsi st rue,thel abort heoryofv aluemustbe
re¬jected.
 Labori sal sonotusedi nt hesamef i
xedpr opor tioni nt hepr o¬duct i
onofal l commodi ti
es.
 Ricardoi gnor est r
anspor tcost si ndet ermi ningcompar at
iveadv antagei nt rade.Thi si s
highlyunr eal isti
cbecauset r anspor tcost spl ayani mpor t
antr oleindet ermini ngt hepat tern
ofwor l
dt rade.
 Theassumpt ion t hatf actor sofpr oduct ion ar eper fectl
ymobi leinternal l
yand whol l
y
i
mmobi l
ei nt ernat i
onal ly.Thi si snotr eal i
st i
cbecauseev enwi t
hinacount ryf act orsdonot
mov efr eelyf rom onei ndust r yt oanot herorf r
om oner egi
ont oanot her.
 TheRi cardi an modeli sr elat ed t ot radebet ween t wo count r
ieson t hebasi soft wo
commodi ti
es.
 Anot herser i
ousweaknessoft hedoct rinei st hati tassumesper fectandf r eewor ldtrade.
But ,i
nr eal ity,wor ldt radei snotf r
ee.
 Thet heor yofcompar at i
veadv ant agei sbasedont heassumpt ionoff ullempl oy ment .This
assumpt i
onal somakest het heor yst aticandunr eal i
st i
c.
 Thet heor ynegl ectst her oleoft echnol ogi cal i
nnov ationsi ninternat i
onal t
rade.
 TheRi car diant heor yisone- si dedbecausei tconsi der sonl ythesuppl ysideofi nter nati
onal
tradeandnegl ectst hedemandsi de.
 Compl et especi ali
zat ionwi l
lbei mpossi bleont hebasi sofcompar ati
v eadv antagei n
produci ngcommodi tiesent eringi nt
oi nt ernat ional trade.
 The cl assi calconcl usion ofcompl ete speci alization bet ween t wo count ri
es can hol d
ground onl y...byassumi ng t rade bet ween t wo count ri
es ofappr oximat elyequal
economi cper formance.
 Thet heor ysi mpl yexpl ainshowt wocount r
iesgai nf rom internationaltrade.Buti tfail
st o
showhowt hegai ns, from t radear edi stribut edbet weencount ri
es.

2.
3.Compar
ati
veAdv
ant
ageandOppor
tuni
tyCost
s
Oppor
tuni
tyCost
sandThepr
oduct
ionpossi
bil
it
ycur
ve

Byrej
ecti
ngthel
abort
heoryofval
ue,wemustal
sor ej
ectRicardo’
sexplanat
ionofcompar
ati
ve
adv
antage,butnotthe law ofcomparat
ive ad¬vantage i
tself
.The law ofcomparati
ve
adv
antagecanbeexpl
ainedonthebasi
soft
heoppor tuni
tycosttheor
y.

Accordi
ngtot heopport
unit
ycosttheory,t
hecostofacommodi t
yistheamountofasecond
commodi t
ythatmustbegi venuptoreleasej
ustenoughresourcestoproduceoneaddi t
ional
unitofthefi
rstcommodi t
y.Conse¬quentl
y,t
henationwiththeloweropportuni
tycostinthe
product
ion ofa commodi t
y has a comparati
ve advantage i
nt hatcommodi ty( and a
compar¬ati
vedisadvant
ageinthesecondcommodi t
y )
.
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page11
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Forexample,basedonTabl e2.4,ifi
nt heabsenceoft radethePortugalmustgiveup0. 89uni t
ofclotht
or el
easej ustenoughr esourcest oproduceoneaddi ti
onalunitofwinedomest icall
y,
thentheopportunit
ycostofwi nei s0.89 unitofcloth(i.
e.,
1W =0.89Ci nthePor t
ugal)
.IflW=
1.2CinEngland,thent heopportunitycostofwi ne(intermsoft heamountofcl oththatmust
begivenup)i sloweri nthePor tugalthaninEngl and.Therefor
e,itcanbesai dthatPor tugal
wouldhaveacompar ati
ve(cost)adv antageoverEnglandi nwineproducti
on.Inat wo-nat i
on,
two¬commodi tywor ld,Engl
andwoul dthenhaveacompar ati
vead¬vantageincloth.

IncompleteSpeciali
zati
on
Therei s one basi
c diff
erence between tr
ade modelunderi ncr
easi
ng and the constant
opportuni
ty costs case.Underconst antcosts,both na¬ti
ons special
i
ze compl et
elyi n
producti
onoft hecommodi tyoft hei
rcompar ¬at
iveadvantage.However,underincreasing
opportuni
tycosts,t
hereisincompletespe¬ci
ali
zati
oninpr
oduct i
oninbothnati
ons.

Thereasonforthi
sisthatascountryIspeciali
zesinthepr oducti
onofX,i tincur
sincr
easing
opport
unit
ycostsinpr
oducingX.Similar
ly,ascountryIIproducesmor eY,itincur
sincr
easing
opport
unit
ycostsinY( whi
chmeansdecl iningopportunit
ycost sofX).Thus,aseachnat ion
speci
ali
zesinpr
oducti
onoft hecommodi t
yofi t
scompar ativ
eadv ant
age,relati
vecom¬modi t
y
pri
cesmov etowardeachot herunti
ltheyar eidenti
calinbot hnati
ons.Thi soccursbefore
ei
thernati
onhascompletel
yspecial
i
zedinpr oduct
ion.

TheGai
nsf
rom ExchangeandSpeci
ali
zat
ion

A countr
y’sgainsfr
om tr
adecanbebr okendowni
ntot
wocomponent
s:t
hegai
nsf
rom
exchangeandthegai
nsfr
om speci
ali
zat
ion.

Supposet hat,f
orwhat everr eason,countr
yIcoul dnotspeci al
izeintheproduct
ionofXwi th
theopeni ngoft r
adebutcont inuedtoproduceatpoi ntA.Starti
ngfr
om pointA,countr
yIcould
export20Xi nexchangef or20Yatt heprevail
i
ngwor ldrel
ativ
epriceofPw =1,andendup
consumi ngatpoi ntToni ndiffer
encecurveII.Event houghcountryIconsumesl essofXand
mor eofYatpoi ntTinr el
at i
ont opointA,i
tisbetteroffthanitwasi naut
arkybecauseTison
higherindiffer
encecurv eII.Themov ementfrom pointAt opointTi nconsumpti
onmeasur es
thegainsf rom exchange.

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page12
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Fi
gur
e2.
11Gai
nsf
rom ExchangeandSpeci
ali
zat
ion

Ifsubsequent
lycountr
yIalsospecial
i
zedintheproduct
ionofXandproducedatpointB,it
couldthenexchange60X f or60Ywiththerestofthewor l
dandconsumeatpoi ntEon
i
ndiff
erencecurv
eI I
I.Themov ementfom T,t
r oEinconsumpt i
onmeasur
esthegai
nsf rom
special
i
zati
oninproducti
on.

Notethatcountr
yIisnotinequi l
ibrium inproduct
ionatpoi
ntAwithtradebecausePA<Pw.To
bei nequi
li
bri
um inproduction,countryIshoul dexpandit
sproduct
ionofXunt i
litr
eaches
pointB, ePB =Pw=1.Count
wher ryII
'sgai nsfr
om tr
adecansimi
lar
lybebr okendownint
ogains
fr
om exchangeandgainsfrom speci al
izati
on.
OfferCur v
eandTer msofTr ade
TheOf ferCur v
esofaNat ion

Offercur
vesincor
porateelementsofbot
hdemandandsupply,weshal
lseehow, i
nter
nat
ional
ter
msoft r
adeareestabl
ishedbytheint
eract
ionofsuppl
yanddemand.Alt
ernat
ivel
y,wecan
saythattheoff
ercurveofanat i
onshowsthewill
i
ngnessoft
henat
iontoimportandexportat
vari
ousre1ati
vecommodi typr
ices.

Theoffercurveofanat i
oncanbeder ivedrathereasi
l
yandsomewhatinfor
mallyfr
om the
nati
on'
s product
ion fr
onti
er,it
si ndif
ference map,and the v
ari
ous hy
pothet
icalrel
ati
ve
commoditypri
cesatwhichtradecouldtakeplace.
Deri
vat
ionofOfferCurv
e

Theter
msoft r
adeorof f
ercur
veoft
hecountri
es,
aredeter
minedbythei
ntensi
tyofdomest
ic
demandforf
oreigngoodsandoft
hefor
eigndemandfordomesti
cgoods.

Figure2. 13(a)showsapr oduct

ionpossi
bil
it
ycur veandasetofcommuni t
yi ndif
ference
curvest hatchar
acteri
zedemandi ncountr
yI.Int heabsenceoft rade,equil
i
brium wi llbe
establi
shedatpointA,whereanindif
fer
encecurvei st
angenti
altothepr oduct
ionpossi bil
it
y
curve.Att hi
spoi
nt,themargi
nalr
ateofsubsti
tut
ioninproduct
ionequalsthemar ginalrateof
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page13
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

substi
tut
ioninconsumpti
on.Thehi
ghestlevelofsat
isf
acti
ont hatthecountr
ycanenjoyunder
autar
kyisthatsymboli
zedbytheindi
ff
erencecurveI.Thepr i
cer ati
othatwil
lberul
ingunder
autar
kyisgivenbythelneP=¼,
i whichistangenti
alt
ot heproduction-
possi
bil
it
ycurv
eandt he
i
ndiff
erencecurv
eatA.

Supposenow t hatweopenupt he,possibil

it
yofi nternati
onaltrade.Producti
onanddemand
condit
ionsincount r
yIareasshowni nFi gur
e1. 9(a).Whichcommodi tycountryIwillexpor
t
andimpor tdependsont heinter
nati
onaltermsoft radet hatareestabli
shed.Letcountr
yIhasa
compar at
iveadv ant
agei n pr
oducti
on ofcommodi tyX and t hatt henew t er
msoft r
ade
establ
ishedundert r
adeareasshownbyt helineP=½ i nFigure2.13( a)
.countr
yIwi llt
hen
produceatpoi ntFandconsumeatpoi ntH,andexpor tFG( 40X)ofcommodi tyXi nexchange
forGH( 20Y)im¬por tsofcommodi t
yY.

Bytrade,countr
yIcanmov etotheindi
ffer
encecurveI
I,whichrepr
esent sahigherlevelof
sati
sfacti
onthandoI.Hadtheter
msoftradebeenevenmor efav
orable,fori
nstancesuchas
repr
esentedbyP=1,thecount
rycoul
dhaver eachedi
ndi
ff
erencecurv
eI IIbyt
radingBC( 60X)
ofXf orCE(60Y)ofY.

Wecannowshowhowcount r
yI'svolumeofexpor t
sandimpor tschangeast heter
msoft r
ade
change.Asithasbeenshowni nFigure2.13( b)
,ont hevert
icalaxi
s,wehav enetexpor tsofY
and on the horizont alaxis we hav e neti mports ofX.The t ri
angle 0GH in Figure( b)
corr
espondstot het radetri
angleHGFi nFi gure2.13(b).I
tshowst hatift
hetermsoft radear e
0H( t
heseter
msoft r adearethesameast hosedepictedbyPF=½i nFigure2.13(a)),
"40Xwi l
l
beexchangedf or20Y.I ft
hetermsoft radei nst
eadshouldchanget o0E( whichcorres¬ponds
toPB =1inFigure2. 13( a)
),60Xwoul dbeexchangedf or60Y( t
hetri
angle0CEcor r
espondst o
thetr
adetri
angleBCEi nFi
gure2.13(a).

Fi
gur
e2.
13Of
fercur
vef
orcount
ryI

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page14
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Inthi
swaywecant r
aceoutapat ter
nofpoi
ntsthatshow how thetradedvol
umeschange
whent heter
msoft r
adechange.Ifwejoint
ogetheral
lthesepointsforcount
ryI
,wegeta
curvesuchas0Ki nFigur
e2.13(b)
.0Kisanexampleofanof fercurv
e.Thusanoffercur
ve
showshowt hev
olumest r
adedchangewhent
hetermsoftradechange.

Theof f
ercurveofthetr
adepartneri
sder
ivedinacomplet
elyanal
ogousway,t
hatis,f
rom i
ts
producti
onfront
ier
,it
sindi
ff
erencemap,andthevar
¬iousrel
ati
vecommodit
ypricesatwhich
tr
adecoul dt
akeplace.

Fi
gur
e2.
13Of
fercur
vef
orcount
ryI
I

Figur
e2.13(a)indi
catesthat
,countryIIstar
tsattheautarkyequili
bri
um pointA’.whentrade
takespl
aceatPH’=Px/Py=2,countr
yIImov estopointF'i
npr oducti
on,exchanges40Yfor20X
withcountr
yI,andr eachespoi
ntH'oni tsindi
ff
erencecurveI I
'
.Tradet r
iangl
eF'G'H'i
nt he
Figur
e2.13(a)correspondst
ot r
adet r
iangleO'G'
H'intheFigure2.13(b),andwegetpoi ntH'
oncountryI
I’
soffercurve.

AtPE’’=Px/
Py =1i nFigure2.13(a),count
ryIIwouldmov ei
nsteadtopoi ntF'inproduct
ion,
exchange60Yf or60Xwi t
hcountryI,andreachpointE'onitsindif
fer
encecur veIII
'.Tr
ade
tr
iangleB'
C'E'
inFigure2.13(a)corr
e¬spondst ot
radetr
iangl
e0'C'E'
inFigure2.13(b)andwe
getpointE'
oncount r
yII’
soffercur
ve.

Joi
ningtheorigi
nwithpoi
ntsH'andE'andot herpoint
ssimil
arl
yob¬tai
ned,wegener at
e
countr
yII
’sof
fercur
veint
herightpanel
.Theoff
ercurveofcount
ryII
’sal
soshowshowmuch
i
mpor t
sofcommodi tyXcountryIIde¬mandstobewi l
l
ingtoexportvar
iousquant
it
iesof
commodityY.
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page15
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

TheEqui
li
bri
um Rel
ati
veCommodi
tyPr
icewi
thTr
ade

Theoffercurvesoft hetwot radi

ngcountri
esi
ntersectatpointE.Thi
si st
heonl yequi
libri
um
poi
ntandt heequi l
ibri
um termsoftradearegiv
enbyt heray0Ef r
om theor i
gin.Onl
yatt his
equi
li
bri
um pr i
cewi l
ltradebebal ancedbetweent het wo na¬ti
ons.Atanyot herrelat
ive
commodi typrice,thedesiredquanti
tiesofim¬por t
sandexpor tsoft hetwocommodi t
ies
woul
dnotbeequal .Thiswoul dputpressur
eont herelat
ivecommodi t
ypricetomov etowar d
i
tsequil
ib¬ri
um level.

Theof f
ercurvesofcount ryIandI Ii
nFigure2.
14inter
sectatpoi
ntE,def
iningequil
i
brium
rel
ati
veprice(
PB =PB’,
=1).AtPB,count
ryIoff
ers60Xfor60Yandcount
ryI
Ioffersexact
ly60Y
for60X.Thustradei
si nequil
i
bri
um atPB.

Fi
gur
e2.
14Equi
l
ibr
ium Rel
ati
veCommodi
tyPr
icewi
thTr
ade

Atanyot herprice,t
radewoul dnotbei nequili
bri
um.Forexampl e,atPF =½,the40Xt hat
countryIwoul dexportwouldfallshor
toft heimportsofcommodi tyXdemandedbycount ryII
.
Inthiscase,theexcessi mportdemandf orcommodi t
yXbycount ryIIt
endstodriv
ePx/ Pyup.
Ast hi
soccur s,countr
yIwillsupplymor eofcom¬modi t
yXf orexport(i
.e.
,count
ryIwillmov e
upitsoffercurve),whil
ecountryIIwil
lreduceitsimportdemandf orcommodi t
yX( i
.e.
,country
IIwil
lmov edowni t
soffercurve).Thi
swi l
lconti
nueunt i
lsuppl
yanddemandbecomeequalat
PB.

Theshapeoft heoffercur
vesaredet erminedbybot hsupplyanddemandcondi ti
onsi nt
he
respecti
vecountri
es.Thelimi
tswithinwhi chtheywi l
lfallar
egivenbyt heautarkytermsof
tradeinthetwocountri
es.Wit
himprov i
ngt er
msoft rade,acountr
yiswill
i
ngtoof fermoreand
mor eofi t
sexport
sf ormoreimports.Af t
eracer t
ainamountoft r
ade,however,thecountry
couldbecomemor eandmor eunwil
li
ngt oacceptani ncreaseintheamountofi mports,ev
en
thoughtheyareoffer
edatimprovi
ngt ermsoft r
ade.

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page16
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Fi
gur
e2.
15.
Inel
ast
icof
fercur
ve

Whenweder iv
edt heothercurve,wear guedasthoughthetermsoft radewer echangingfor
someexogenousr easonandt henderivedtheshapeofthecur ve.Thiswasapedagogi cal
deviceandmustnotbemi sunderst
ood.Theoffercurv
eisagener al
-equil
ibr
ium concept.I
tis
determinedjoi
ntl
ybypr oductionandconsumpt ioncondi
ti
ons.Itismor eappropri
atetosay
thatthesecondit
ionsdeterminet heshapeofthetradi
ngpartner
s'offercurves,whichinturn
determinetheter
msoft rade,

ChangeI
nTer
msOfTr
ade

Theter msoftradeofanationaredefinedasther
ati
oofthepri
ceofitsexpor
tcommodityto
thepriceofi
tsimportcommodi ty
.Sinceinatwo¬nat
ionworl
d,theexpor
tsofanat
ionarethe
i
mpor tsofitst r
adepartner,thetermsoft r
adeoft he'
lat
terareequaltotheinv
erse,or
reci
procal
,oftheter
msoft radeoftheformer
.

.Thesetermsoft radear eoftenrefer

redtoast hecommodi tyornetbart erter
msoft r
ade.As
supplyanddemandconsi der
ati
onschangeov ert i
measar esultoff
actor saffect
ingdemand
andsupplyoftradable,offercurveswillshi
ft,changingthev ol
umeandt het er
msoft r
ade.An
i
mpr ovementinanat ion'ster
msoft r
adei susuallyregardedasbenefici
alt othenat i
oninthe
sensethatthepricest hatthenat i
onreceivesf orit
sexpor t
sriserel
ativ
et othepricesthati
t
paysforimport
s.

Forinstance,ifanat ion'
st asteschangeanddesi reforit
simportcommodi tyincr
eases,t
he
nat
ion'soffercurvewi llr
otateclosertotheaxismeasuri
ngthecommod¬i t
yofi t
scompar at
ive
advantage.Ther easonf ort hi
sist hatthenati
onisnow will
i
ngtogiveupmor eofitsexport
commodi tyinexchangef oranygi venamountoft heimportedcommodi t
ybecauseofi ts
i
ncreaseddesi r
ef ortheimpor tedcommodi ty.Thi
sresul
tsinanexpandedvolumeoft r
adebut
i
ndet eri
orati
onint henation'stermsoft r
ade.

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page17
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Fi
gur
e2.
17Shi
fti
nof
fercur
ve

Asi thasbeenshowni nFi

gure2.17,countryI’
st er
msoft r
adedeterior
atefrom Px/Py =1at
pointE1toPx/Py=1/2atpointE2andt hevol
umeoft radeincr
easesaftercountryI
'
sof fercur
ve
shi
f t
s(rotat
es)from 1to1*asar esultofi
tsincr
easeddesi r
eforit
si mportedcommodi t
yY.
Thesamewoul dbet r
ueifanim¬pr ovementintechnologyoranincreaseinresourcesshift
ed
countryI'
soffercur
veto1*.

Similar
ly,anincreaseincountryI
I'
sdesireforimpor t
sofcommodi tyX,ani mprovementinit
s
technology,orincreasedavail
abi
li
tyofresourcesov erti
mewi l
lrot
atecount r
yII'
soffercur
ve
upwar d(counter-cl
ockwise)
.Thiswillr
esul
tindet eri
orat
ionincount ryII
’ster
msoft radeand
anexpansi onoft rade.Forexample,ifcountryII'
sof f
ercur verotatesfrom 2t o2*whi l
e
assumi ngnochangei ncountr
yI,thencountr
yI I
'
st ermsoft r
adedet eri
orat
efrom Py/
Px=1at
pointE1 toPy/Px =1/ 2(t
heinver
se,orreci
procal,ofPx/Py =2)atpoi ntE3andt hevolumeof
tradeexpands.

2.
4.Heckscher
-Ohl
inTheor
yofTr
ade

Themoder ntheoryofi
nternat
ionaltradeortheHeckscher-Ohl
in(
H.O.
)theorywasdev eloped
byt woSwedisheconomi st
s,El iHeckscher
,andhi sstudentBer
ti
lOhl
in,i
n1920s.TheH. O
theoryst
atesthatt
hemaindet ermini
ngf act
orfort
hepat t
ernofpr
oduct
ion,speci
ali
zati
onand
tradeamongcountri
esi
st herelati
veavail
abil
it
yoffact
orendowmentsandfactorpri
ces.

Regionsorcount r
ieshavedif
fer
entfact
orendowment
sandtherefor
ehavef
actorpri
ces.Some
countrieshav emuchcapital
,ot
hershavemuchlabor
.Thetheorysayst
hatcountr
iesthatare
ri
chincapi talwi
ll
exportcapi
tal
int
ensiv
egoodsandcount
ri
esthathavemuchlaborwillexpor
t
l
abor -
intensiv
egoods.

TheAssumpt
ions

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page18
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

TheHeckscher
-Ohl
i
ntheor
yisbasedont
hef
oll
owi
ngassumpt
ions:

I
tisat
wo-
by-
two-
by-
twomode:t
her
ear
etwocount
res(
i AandB)
,twocommodi
ti
es(
XandY)
,
andt
wof
act
orsofpr
oduct
ion(
capi
tal
andl
abor
).

Bot
hnat
ionsuset
hesamet
echnol
ogyi
npr
oduct
ion:bot
hcount
ri
eshav
eaccesst
oanduse
t
hesamegener
alpr
oduct
iont
ech¬ni
ques.

Commodi
tyXi
slabori
ntensi
veandcommodi
tyYi
scapi
tali
ntensi
vei
nbot
hcount
ri
es:The
l
abor-
capit
alrati
oishigherforcommodit
yXt hanforcommodi t
yYi nbothcountr
iesatthe
samerelat
ivefactorpri
ces.Thi
sisequiv
alenttosayingthatthecapit
al-
laborr
ati
o( K/
L)is
l
owerforXt hanforY.Butitdoesnotmeant hattheK/Lrat
ioforXisthesamei nCountry1
andCountr
y2, onl
ythatK/Lisl
owerforXthanforYinbothcountr
ies.

Const
antr
etur
nst
oscal
eint
hepr
oduct
ionofbot
hcommodi
ti
esi
nbot
hcount
ri
es:

I
ncompl
etespeci
ali
zat
ioni
npr
oduct
ioni
nbot
hcount
ri
es:evenwi
thf
reet
radebot
hcount
ri
es
cont
inuet
opr
oducebot
hcom¬modi
ti
es.Thi
simpl
i
est
hatnei
theroft
het
wocount
ri
esi
sver
y
small
.

Equalt
ast
esi
nbot
hcount
ri
es:demandpr
efer
¬ences,asr
efl
ect
ed'
i
ntheshapeandl
ocat
ion
ofi
ndi
ff
erencecur
ves,ar
ei denti
cali
nbothcountr
ies.Thus,whenr
elat
ivecommodit
ypri
ces
ar
eequali
nthetwocountr
ies,bothcount
ri
eswil
lconsumeXandYi nthesamepropor
ti
on.

Per
fectcompet
it
ioni
nbot
hcommodi
ti
esandf
act
ormar
ket
sinbot
hcount
ri
es:

Per
fectf
act
ormobi
li
tywi
thi
neachcount
rybutnoi
nter
nat
ionalf
act
ormobi
li
ty:

Not
ranspor
tat
ioncost
s,t
ari
ff
s,orot
herobst
ruct
ionst
othef
reef
lowofi
nter
nat
ionalt
rade:

Fact
orI
ntensi
ty,
Fact
orAbundance,
andt
heShapeoft
hePr
oduct
ionFr
ont
ier

Fact
ori
ntensi
ty:I
nawor
ldoft
wocommodi
ti
es(
XandY)andt
wof
act
ors(
laborandcapi
tal
),
wesayt hatcommodi
tyY i
scapi
tali
ntensi
veift hecapi
tal
-l
aborr
ati
o(K/
L)usedi
nthe
pr
oduct
ionofYisgr
eat
ert
hanK/
Lusedintheproducti
onofX.

Notet hatitisnottheabsolut
eamountofcapi taland l aborused i nthepr oducti
on of
commodi ti
esXandYt hati
simport
antinmeasuri
ngt hecap¬i t
alandl abori
ntensit
yofthetwo
commodi ti
es,butt
heamountofcapit
alperuni
toflabor(i.
e.,K/L).Forexample,Country1can
produce1Ywi th2Kand2L.Thus,K/ L=2/ 2=1f orY.Ont heot herhand,3K and12Lar e
requi
redtoproduce1X,i
nCounty1.ThusK/
r L=1/4f orX.SinceK/ Lishigherforcommodi t
yY
thanforcommodi t
yX,wesayt hatcommodi t
yYiscapi talintensi
veandcom¬modi t
yXi sL
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page19
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

i
ntensi
veinCount
ry1.IfCount
ry2,K/ Lis4f orYand1f orX.Ther
efor
e,Yi
sthecapi
tal
i
ntensi
vecommodi
tyandXisthelabori
ntensi
vecommodi
ty.

Fact
orabundance:Ther
ear
etwoway
stodef
inef
act
orabundance.

i
.I ntermsofphy sicalunits( i.
e.,i
nt ermsoft heov er al
lamountofcapi talandl aborav ail
able
toeachcount ry).Fori nstance, Country2i scapitalabundanti fther at
iooft het otalamount
ofcapitaltot het otalamountofl abor( TK/TL)av ailableisgr eaterthant hatinCount ry1.
Notethatitisnott heabsol uteamountofcapi t
alandl aborav ailabl
eineachcount rythatis
i
mpor tantbutt her ati
o.Thus, Count ry2canhav el esscapi t
al t
hanCount r
y1andst i
l
lbet he
capit
al¬abundantcount ryifTK/ TLinCount ry2exceedsi nCount r
y1.
i
i
.I ntermsofr elativef actorpr i
ces( i.
e.,inter
msofr entalpriceofcapi talandpr iceofl abor
ti
mei neachcount ry
).Fori nstance,int er
msoff act orpr i
ce,Count ry2i scapitalabundanti f
therati
ooft her entalpriceofcapi t
altot hepri
ceofl abortime( PK/PL)i slowerinCount ry2
thaninCount ry1.Si ncet her entalpriceofcapit alist heinterestr at
e&whi let hepr i
ceof
l
abori sthewager ate( w),PK/ PL=r /
w.Onceagai n,itisnott heabsol utelevelofwageor
i
nterestthatdet er¬mi neswhet herornotacount r yist hecapitalabundantcount rybutitis
rl
w.Forexampl e,rmaybehi gheri nCount r
y2t hani nCount ry1,butCount r
y2wi llsti
llbe
thecapitalabundantcount r
yifr l
wi slowertheret hani nCount ry1.

Sincewehav eassumedt hattast

es,ordemandpr ef
erences,arethesameinbat hcountri
es,
thet wodefinit
ionsoff
actorabundancegiv
ethesamecon¬cl usi
onsinourcase.Thatis,wit
h
TK/ TLlargerinCountry2t haninCountry1i nthef aceofequaldemandcondi t
ions(and
technology),PK/PLwil
lbesmal l
eri
nCountry2.Thus,Country2isthecapi
talcountr
yinterms
ofbot hdefi
niti
ons.

Fi
gur
e2.
18Shapeoft
hepr
oduct
ionpossi
bil
i
tycur
ves

I
fCount
ry2 i
sthe capi
talabundantcount
ryand commodi
tyY i
sthe capi
tali
ntensi
ve
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page20
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

commodi ty,Countr
y2canpr oducerelati
vel
ymor eofcommodi t
yYthanCount r
y1.Ther ef
ore,
i
tspr oduct
ionfront
ier,f
ig3.
1,isskewedt owardthev er
ti
calaxismeasuri
ngcommodi t
yY.On
theotherhand,Country1isthelaborabundantcountryandcommodityXist helabori
ntensi
ve
commodi ty,Countr
y1canpr oducerelati
vel
ymor eofcommodi t
yXthanCount r
y2.Thisgives
apr oducti
onf r
ontierforCountry1t hatisrel
ativ
elyf l
att
erandwi derthanthepr oducti
on
front
ierofCountry2(ifwemeasur eXalongthehorizont
alaxis)
.

TheHeckscher
-Ohl
inTheor
ies

Basedontheassumpti
onsofH-Ot heor
ypr
esentedbef
ore,theHeckscher-
Ohli
ntheorem can
best edas:Acount
at rywil
lexpor
tthecommoditywhoseproduct
ionrequi
restheint
ensiveuse
ofthecountr
y'srel
ati
velyabun¬dantandcheapfactorandi mportt
hecommodi t
ywhose
pr
oduct
ionrequi
restheint
ensi
veuseofthecount
ry'
srelat
ivel
yscar
ceandexpensi
vefact
or.I
n
shor
t,therelati
velylabor
-ri
chcountryexpor
tsther
elat
ivel
ylabor
-i
ntensi
vecommodi
tyand
i
mportstherelat
ivelycapi
tal
-i
ntensi
vecommodit
y.

Ofall,thepossi blereasonsf ordi f

fer
encesinr elat
ivecommoditypr i
cesandcomparati
ve
advantage among count r
ies,the H-Ot heor
em i sol
atesthe di
ff
erence inrel
ati
vel
yfact
or
abundance,orf actorendowment s,amongcount riesastheorydeterminantofcompar
ati
ve
advantageandint er¬nati
onaltrade.Forthisr
eason,theH-Omodeli softenref
err
edtoasthe
fact
or-propor
ti
onsorf act
or-endowmentt heor
y.

Theref
ore,accor
dingtoH-Ot heorem,eachcount
ryspe¬cial
izesintheproduct
ionandexport
ofthecommodi tywhichintensi
velyusesthecountr
y’srel
ativ
elyabundantandcheapfactor
(comparati
veadvantage)andi mportsthecommodi t
ywhi chi nt
ensi
vel
yusest hecount
ry’s
rel
ati
vel
yscarceandexpensivefactor(
it
scomparati
vedisadvantage)
.

Thus,t
heH- Otheo¬r
em post ul
atesthatt
hediff
erencei nrel
ati
vefactorabundanceandpr i
ces
i
st hecauseofthepr etradediffer
encei
nrelat
ivecommodi typr
icesbet weentwocount r
ies.
Thisdi
ffer
enceinrelat
ivefactorandcommodi t
ypr icesisthentr
anslatedintoadiff
erencein
absol
utefactorandcommodi t
ypr i
cesbet
weent het wocountries.Itisthisdif
ferencein
absol
utecommodi t
ypricesbetweent het
wocount r
iesthatisthei
mmedi at
ecauseoftrade.

I
ll
ust
rat
ionofHeckscher
-Ohl
inTheor
y

Asi ndi
cat
edbefore,Countr
y1i st heL- abundantcount ryandit
sproducti
onf ronti
erisskewed
alongtheXaxisbecausecommodi t
yXi stheL-intensivecommodi t
y.Fur
ther¬mor e,sincethe
twocount r
ieshaveequaltastes,t heyf acet hesamei ndif
fer
¬encemap.I ndiffer
encecur veI
(whichiscommonf orbothcount ries)ist an¬genttoCount ry1'
sproducti
onf ronti
eratpoi ntA
andt oCountry2'sproducti
onf ront i
eratA' .I
ndifferencecurveIisthehi ghestindiffer
ence
curvethatCountr
y1andCount ry2canr eachi nisolati
on,andpointsAandA' representthei
r

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page21
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

equi
l
ibr
ium poi
ntsofpr
oduct
ionandconsumpt
ioni
ntheabsenceoft
rade.

Thet angencyofindi
ff
erencecurv
eIatpoi nt
sA andA’defi
nestheautar
ky,orno¬t rade,
equil
i
br i
um rel
ati
vecommoditypri
cesofPA i
nCountr
y1andPA’inCount
ry2.SincePA <PA’,
Country1hasacompar a¬t
iveadv
antagei
ncommodi t
yX,andCount
ry2hasacompar ativ
e
advantageincommodityY.

Fi
gur
e2.
19Hecksher
-Ohl
i
nModel

Ther ightpanel ,Fi

gure2.19,showst hatwithtradeCount ry1speciali
zesint hepro¬duct
ionof
commodi tyX, andCount ry2speci al
izeintheproductionofcom¬modi tyY( seethedir
ect
ionof
thear rowsont hepr oductionfrontiersoft hetwocount ri
es).Speciali
zationinproducti
on
proceedsunt ilCountr
y1hasr eachedpoi ntBandCount r
y2hasr eachedpoi ntB'wherethe
transformationcur vesoft het wocount ri
esar etangenttot hecommonr elati
vepri
celi
nePB.
Count ry1wi llthenexportcommodi tyXi nexchangef orcommodi tyYandconsumeatpoi ntE
oni ndiff
erencecur veI I(
tradet r
iangleBCE).Ont heot herhand,Count ry2wi l
lexpor
tYf orX
andconsumeatpoi ntE' ,
whi chcoincideswithpointE( t
radetri
angleB'C'E'
).

NotethatCount ry1'sexportsofcommodi t
yXequalCount r
y2'simportsofcommodi t
yX( i
.e.
,
BC=C'E'
).Similarly,Country2's exports ofcommod¬i tyY equalCount r
y1'si mports of
commodi tyY(i.e.;B'C'
=CE).At,PX/PY >PB,Countr
y1want st oexportmor eofcommodi tyX
thanCountry2want stoimportatthishighrel
ati
vepr i
ceofX, andPX/PYfall
stowardPB.Onthe
otherhand,atPX/PY<PB, Country1want stoexportlessofcommodi tyXt hanCountry2want s
toimportatthi
sl owr el
ati
vepriceofX, andPX/PYri
sest owardPB.Thi
st endencyofPX/PYcould
alsobeexplai
nedi ntermsofcom¬modi t
yY.

Alsotobenot edi sthatpoi ntEinv

olvesmor eofYbutl essofXt hanpoi
ntA.Nev ert
heless,
Country1gainsf rom tradebecausepoi ntEisonhigherindi
ff
erencecurv
eI I
.Simil
arl
y,even
thoughpointE'invol
v esmor eXbutlessYt hanpoi
ntA',Countr
y2i sal
sobet t
eroffbecause
pointE'i
sonhi gherindiff
erencecurveII
.Thi
spatter
nofspeciali
zati
oninproducti
onandtrade
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page22
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

andconsumpti
onwil
lremai
nthesameunti
lther
eisachangei ntheunder
lyi
ngdemandor
suppl
ycondi
ti
onsi
ncommodityandf
act
ormarket
sinei
therorbot
hcount
ri
es.

Fact
or-
Pri
ceEqual
izat
ionTheor
em

Thef actor-pri
ceequalizat
iontheor
em isacor oll
aryofH-Qtheorem andholdsonlyiftheH-O
theorem hol twasSamuel
ds.I sonwhor igorouslyprovedt
hisfact
or-
priceequal
i
zationtheor
em.
Fort hi
sr eason,factor
-pri
ceequali
zati
ont heorem issometi
mesr efer
redtoast heHeckscher
-
Qhlin¬Samuel sontheorem (
H-O-Stheor
em) .

Based on theassumptionsofH- Ot heorypresent

ed before,thef actor-
pri
ceequal i
zati
on
theor
em canbest at
edas:I nt
ernat
ionaltradewillbr
ingaboutequalizati
oni nther el
ativeand
absol
utereturnst
ohomogeneousf ac¬torsacrosscountri
es.Simil
arl
y,inter
nationaltr
adewi ll
causethereturn(
int
erest)tohomogeneouscapi t
al(i
.e.
,capit
alofthesamepr oducti
v i
tyand
ri
sk)tobethesamei nalltr
adi
ngcount ri
es.Thatisbothrel
ati
veandabsol ut
efactorpriceswill
beequali
zed.

From secti
on3. 2.2.
, weknowt hatintheabsenceoft radetherelat
ivepri
ceofcommodi t yXi s
l
oweri nCount ry1t hani nCountry2becauset her elati
vepri
ceofl abor,orthewager ate,is
l
oweri nCount ry1.AsCount ry1Speci al
i
zesi nt hepr oducti
onofcommodi tyX( t
hel abor
i
ntensive commodi ty)and reducesi tspr oducti
on ofcommodi tyY (the capitali
ntensi ve
commodi ty),t
her elati
vedemandf orlaborr i
ses,causi ngwages( w)torise,whiletherelat i
ve
demandf orcapi talfall
s,causingthei nter
estr e(
at r)tofal
l.Theexactop¬posi teoccur sin
Country2.Thati s,asCount r
y2speci alizesinthepr oducti
onofYandr educesi t
sproduct ion
ofXwi thtrade,it
sdemandf orLf all
s,causingw t of all
,whil
eitsdemandf orcapi
talr
isesand
ngrt
causi or i
se.

Wecangof urtheranddemonst r
atethati nt
ernati
onalt radenotonl ytendstor educethe
i
nternat
ionaldiffer
encei nt her eturnstohomogeneousf actors,butwouldi nf
actbr i
ngabout
completeequalizati
oninr elati
vef ac¬torpri
ceswhenal loftheassumpt ionsmadehol d.Thi
sis
sobecauseasl ongasr elat i
vef actorpri
cesdi f
fer,rel
ativecommodi typr i
cesdif
ferandt r
ade
conti
nuest o expand.Butt heexpansi onoft rader educest hediff
erenceinf actorpri
ces
betweencount ri
es.Thus,i nternationaltr
adekeepsexpandi nguntilr
elati
vecommodi t
ypri
ces
arecompl et
elyequalized,whi chmeanst hatrel
ativefactorpr i
ceshav ealsobecomeequali n
thetwocount r
ies.

Cr
it
ici
smsofH-
OTheor
em

Ohl
i
n’st
heor
yhasbeencr
it
ici
zedont
hef
oll
owi
nggr
ounds:

 Two-
by-t
wo-by
-twoModel
.Ohlinhasbeencr i
ti
cizedf
orpresent
ingtwo¬by -
two-
by-
two
modelbasedonover
simpl
if
iedassumpt
ions.But,asOhl
i
nhi mselfpoi
ntsout
,itcanbe
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page23
 Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

extendedt omanyr egions, manycommodi tiesandmanyf actors.

 StaticTheor y.Liket hecl assicalt heor y
,t heOhl i
nmodeli sst ati
ci nnat ure.Itonl ygi ves
somechar acteri
st i
csofaneconomyatagi venpoi nti nt i
me
 Fact orsnotHomogeneous.Thet heor yassumest heexi stenceoft hehomogeneousf actors
i
nt het wocount r
ieswhi chcanbemeasur edf orcal culati
ngf actorendowmentr ati
os.But ,
i
nr eality,not wof act orsar ehomogenousqual itativelybetweencount ri
es,andev enone
factori sofv ari
oust ypes.
 Product ionTechni quesnotHomogeneous.Agai n, theOhl inmodelassumeshomogeneous
product i
ont echni quesf oreachcommodi t
yi nt hetwocount ri
es.
 Tast esandDemandPat t
er nsnotI dentical.TheH. Ot heoryisbasedont heassumpt i
onof
i
dent i
cal tastesanddemandpat t
er nsofconsumpt ioni nbot hcount ri
es.
 NoConst antRet urns.Theassumpt iont hatt herear econst antr eturnst oscalei sal sonot
realisti
cbecauseacount ryhav ingr ichfact orendowment softenobt ainstheadv ant agesof
economi esofscal et hroughl esserpr oduct i
onandexpor t
s.Thust herearei ncr easing
returnst oscal erathert hanconst ant .
 Transpor tCost sinf l
uenceTr ade.Thi stheor ydoesnotconsi dert ranspor tcost si nt r
ade
betweent wocount ri
es.
 Unr ealisticAssumpt ionsofFul lEmpl oymentandPer fectCompet i
tion.TheH. Ot heoryi s
basedont heunr eal i
sticassumpt ionsoff ul lemploy mentandper f
ectcompet i
ti
onbecause
therei snei therfullempl oy mentnorper f
ectcompet it
ioninanycount ryoft hewor ld.Rather,
count r
iesdonothav ef r
eet radebuti mposet rader estrict
ionsonal argescal e.
 Fact orPr i
cesdonotdet ermi neCommodi tyPr i
ces.Commodi typr icesar edet er mi nedby
thef act orpriceswhi chi ntur n,det ermi necost s.

Despi
tethesecrit
ici
sms,t
heOhl
int
heor
yofi
nter
nati
onalt
radeisdefi
nit
elyanimpr
ovementov
er
theclassi
caltheoryasitat
tempt
stoexpl
ainthebasisofinter
nati
onaltr
adeinthegeneral
equil
i
brium set
ti
ng.

Lear
ningact
ivi
ty

Assi
gnment1

Under
standingandanaly
singt
hetheori
esofinter
nat
ionalt
radewithregar
dtot hebasi
sand
gai
nfrom tr
ade,debat
eandcount
er-
debateonvari
oustheor
iesofi
nter
nati
onal
trade

Cont
inuousAssessment

 Test2(
5point
s)
 Assi
gnment(2poi
nts)

Summar
y

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page24
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Themer cant
il
ist
sbeliev
edt hatanati
oncouldgainini
nter
nat
ionaltr
adeonlyattheexpenseof
othernati
ons.Asar esult
,theyadvocatedrest
ri
cti
onsonimports,i
ncent
ivesforexport
s,and
st
r i
ctgover
nmentregulati
onofalleconomicacti
vi
ti
es.

AccordingtoAdam Smith,tr
adeisbasedonabsol ut
eadv ant
ageandbenefit
sbot hnati
ons.
Thatis,wheneachnat i
onspeciali
zesintheproducti
onoft hecom¬modityofitsabsolute
advantageandexchangespartofitsout
putforthecommodi tyofit
sabsol
utedisadvant
age,
bothnat i
onsendupconsumi ngmor eofbot hcommodi t
ies.Absol
uteadvant
age,howev er
,
expl
ainsonlyasmallpor
tionofi
nter
nati
onalt
radetoday.

Dav i
dRicardoint
roducedthelawofcompar at
iveadvantage.Thispos¬tul
atesthatev ennone
nationi
sl esseff
ici
entthantheothernationi
nt heproducti
onofbot hcommodi ties,ther ei
s
sti
llabasisformutual
lybenef
ici
altr
ade.Because,t
helesseff i
¬ci
entnati
oncouldspeci alizei
n
theproductionandexportthecommodi tyinwhichit
sabsol utedi
sadvantagei
sl east( thisi
s
the commodi tyofi t
s com¬parat
ive advant
age).Ricardo,howev er
,explai
ned hi sl aw of
comparativead¬vant
ageintermsofthelabortheor
yofv al
ue,whichisunaccept
able.

Lett
erHaber l
erexplainedthel awofcom¬par ativeadvant
ageint ermsoft heopport
unit
ycost.
The opportunit
ycostst atest hatthe costofa commodi t
yi st he amountofa second
commodi tythatmustbegi venupt oreleasejustenoughr esourcest oproduceoneadditi
onal
uni
toft hefir
stcommodi ty
.Theoppor tunitycostofacommodi t
yi sequaltotherel
ati
veprice
ofthatcommodi t
yandi sgivenbyt he( absolute)sl
opeoft hepr oducti
onpossibi
li
tyfr
ontier
.
Thesl opeoft hepr oduct
ionf ront
iergi vest hemar gi
nalrateoft r
ansformati
on( MRT).A
str
aightli
neproductionpossi bil
i
tyfr
onti
err ef
lectsconstantopportunit
ycosts.

Theoffercur
veofanat i
onshowshowmuchofi tsimportcommodit
ythenati
ondemandst o
bewill
i
ngt osuppl
yvari
ousamount sofitsexportcommodity.Theof
fercur
veofanati
oncan
be deri
ved fr
om its product
ion f
ront
ier,i
tsi ndi
ff
erence map,and the v
ari
ous r
elat
ive
commodi t
ypri
cesatwhichtradecoul
dtakeplace.

Accordi
ngt otheHeckscher-Ohli
n(H-O)theo¬rem,anationwillexpor
tthecommodi t
yintensiv
e
i
ni t
srelati
velyabundantandcheapf actorandimportthecommodi t
yintensi
veini
tsrelati
vely
scarce¬andexpensivefactor.Accor
dingt othef
actor
-priceequali
zat
iontheorem,i
nter
national
tr
adewi llbri
ngaboutequal i
zati
onofr elati
veandabsol uteretur
nstohomogeneousf actor
s
acrossnations.

Outofal lthepossibleforcesthatcouldcauseadi ff
erenceinpr e-
tr
ader elat
ivecommodity
pri
cesbet weennations,HeckscherandOhlinisolat
ethedi f
fer
enceinf actorendowments(in
thefaceofequalt echnologyandt ast
es)ast hebasicdeterminantorcauseofcompar ati
ve
advantage.Int
er¬nati
onalt radecanalso beasubst i
tutefort heinternat
ionalmobil
it
yof
fac¬t
orsinequali
zingrelat
iveandabsoluter
eturnstohomogeneousf actorsacrossnati
ons.
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page25
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

CHAPTERTHREE:ECONOMI
CGROWTH,
DEVELOPMENTANDI
NTERNATI
ONALTRADE

Whatki ndofrel
ati
onshi
pdoy outhi
nkbetweeni nt
ernat
ionalt
radeandeconomi
cgr
owt hand
development?Doesint
ernat
ionaltr
adefaci
l
itateandfost
ereconomicgrowt
handdev
elopment
fornati
onsparti
cul
arl
yfordevelopi
ngcountr
ies?

3.
1. I
nter
nat
ionalTr
adeandEconomi
cGr
owt
h

I
ntr
oduct
ion

Asidef r
om t r
adebasedont echnol
ogicalgapsandpr oductcycleswhi chisdynamicinnature,
thetradet heorydi scussedt husfariscompl etel
ystati
cinnat ure.Gi v
enthenat i
on’
sfactor
endowment s,technology,andt astes,wepr oceededt odeterminet henation’
scompar ati
ve
advantage and t he gainf rom t r
ade.Howev er
,f act
orendowment s change overtime;
technologyusual l
yimpr oves;andtastesmayal sochange.Asar esultthenati
on’scomparati
ve
advantage al so changes ov ertime.Ther eforethi
s secti
on ext ends the tr
ade modelt o
i
ncor porat
et hesechanges.

Gr
owt
hoff
act
orsofpr
oduct
ion

Thr
ought ime,anati
on’
spopul
ati
onusual
l
ygrowsandwi thitthesi
zeofitslaborfor
ce.
Si
milarl
y,byuti
l
izi
ngpar
tofi
tsr
esour
cestopr
oducecapi
talequi
pment
,thenat
ionincr
eases
i
tsstockofcapi
tal
.

Althoughtherearemanydiffer
enttypesofl aborandcapital
,forsimpli
cit
yweassumet hatal
l
unitsoflaborandcapi
talar
ehomogenousandal soassumet hatlaborandcapi t
alaret
heonly
factorofproducti
on.I
ntherealwor l
d,therearealsonaturalr
esourceswhi chcanbedepleted
(suchasmi neral
s)ornew onesf oundt hroughdiscoveri
es.Theassumpt ionofconstant
returnst
oscal eandthenati
onpr oducesonl ytwocommodi t
ies(commodi tyXwhi chi
slabor
i
ntensiveandcommodi tyY,whichiscapitali
ntensi
ve)conti
nuetobeconsi dered.

Laborgr
owt
handcapi
tal
accumul
ati
onov
ert
ime

Ani ncreasei nendowmentofl aborandcapitalovert i

mecausest henat i
on’
spr oducti
on
fr
ontiertoshiftout
war d.Thetypeanddegreeoftheshiftdependsonther ateatwhichLandk
grow.I fLandKgr owatsamer at
e,thenati
on’sproducti
onf r
onti
erwillshi
ftoutev enlyinall
dir
ectionsatt herateoff act
orgrowth.Asar esul
tthesl opeoftheol dandnew pr oducti
on
fr
ontierswillbethesameatanypoi ntwheretheyarecutbyt herayfr
om t heori
gin.Thisisthe
caseofbal ancedgr owth.

Fi
gure3.1showsvar
ioust y
pesofhypot
het
icalf
act
orgr
owthinnati
onone.Thel
eftpanel(
a)
showsthecaseofbalancedgr
owth,i
fKandLdoubledtonat
ionone.Wi
thconst
antret
ursto
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page26
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

scal
e,themaximum amountofeachcommodi tythatnationonecanpr oduceal sodoubles
fr
om 140Xto280Xor70Yt o140Y.Notethatt
heshapeoft heexpandedproducti
onf r
onti
eris
i
denti
caltotheshapeofpr
oducti
onfr
onti
erbef
oregrowth.Sothatthesl
opofthet wofront
iers,
orPX/
PYisthesameatsuchpointsBandB’,
wheretheycutbyar ayfr
om t
heor i
gin.

130

14

80
B’ A
70
A B

50 100 140 280 140 150 225

Fi
gur
e3.
1Gr
owt
hofl
aborandcapi
talov
ert
ime

Therightpanel(b)repeatsnati
onone’sf ronti
erbeforegrowthwhi chis140Xand70Yand
showst wo additi
onaltwo producti
onfrontier
sonewi thLdoubl esandt heotheronlyK
doubl
ing.Whenonl yLdoubles,t
heproducti
onf r
onti
ershift
smor ealongt heX-axis,
measuring
theL-intensi
vecommodi t
y.I
fonlyKdoubl es,thepr
oductionfrontiershift
smoret owardsY-
axi
s,measur i
ngtheK-intensi
vecommodi ty
.Wehav et okeepinmi ndt hatwhenonlyLdoubles
themaximum out putofcommodi t
yXdoesnotdoubl e.I
tonlyri
sesf rom 140Xto275X.ForX
todoublebothLandKmustdoubl e.Si
milarl
ywhenonl yKdoublest hemaxi mum outputofYis
l
essthandoubl e,
onlyfr
om 70Yt o130Y.

Techni
calpr
ogr
essandt
henat
ion’
spr
oduct
ionpossi
bil
it
ycur
ve

Several
empiricalstudiesshowt hatmostoft hei
ncreasei nrealpercapit
alincomeinindustr
ial
nati
onsisduet ot echnicalprogressandmuchl esst ocapi t
alaccumul ati
on.Howev er
,the
analy
sisoft echnicalprogressi smuchmor ecompl ext hantheanal ysi
soff actorgrowth
becausetherearesev eraldefi
nit
ionsandt y
pesoft echnicalprogress,
andt heycantakeplace
atdif
fer
entratesint heproducti
onofeitherorbothcommodi ti
es.

Asinthecaseoff actorgrowth,allt
ypesoftechni
calpr ogresscausethenat i
on’
sproducti
on
possi
bil
i
tycurvetoshiftoutward.Thetypeandthedegreeoft heshif
tdependsont hetypeand
rat
eoft echni
calprogressinei t
herorbot hcommodities.Nonneut raltechni
calpr
ogressis
ext
remelycomplexandcanonl ybehandl edmathemati
cal l
yinmostadv ancedtext
s.

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page27
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Witht hesamer at
eofneut ralt
echnicalprogressi
ntheproductionofbothcommodi t
ies,the
nati
on’ sproducti
onpossi bili
tycurvewillshi
ftoutevenl
yinalldirecti
onsatthesamer at
eat
whicht echnicalprogresst akesplace.Thishast hesameef fectont henati
on’
sproduction
possibili
tycurveasbal ancedf act
orgr owth.Thus,theslopeoft henati
on’snew andol d
product i
onpossibil
it
ycur vewi l
lbet hesameatanypoi ntwher etheyarecutbytherayfrom
theorigin.

Analogous r easoning explai

ns t he shi f
ti nt he production possi
bili
ty cur
ve when t he
productivi
tyoflaborandcapi taldoubl esonlyintheproductionofcommodi t
yY.final
lyi
tmust
bepoint edoutt hat,i
ntheabsenceoft rade,al
ltypesoft echni
calprogresstendstoincrease
thenation’swel far
e.Ther easoni st hatwi t
hthehi gherproducti
onpossi bi
li
tycurveandt he
samel aborandpopul ati
on,eachci t
izencoul dbemadebet teroffaft
ergrowt ht
hanbeforeby
anappr opri
ateredistr
ibuti
onpol i
cy.

3.
2. I
nter
nat
ional
TradeandEconomi
cDev
elopment

Thet
heor
yofeconomi
cdev
elopment

Inf acti nternat ionalt rademaymaxi mizewel f

areofdev elopingnat ionsi nt heshor tt er
m.
Howev er,thesenat ionsbel i
evet hatthispat ternofspeci alizati
onandt radel eadst hem t oa
subor di nateposi ti
on wi th devel
oped nat i
onsand keepst hem fr om r eaping t hedy nami c
benef itsofi ndust ri
esandf rom maxi mizingt heirwelfarei nthel ong- run.Thedy nami cbenef its
resultingf rom i ndust r
ialpr oductionincludesamor et rainedl aborf orce,mor ei nnovat i
ons,
higherand mor e st able pr i
cesf ort he nat ion’
sexpor ts,and hi gheri ncome f orci tizens.
Ther efor e al lormostoft hese dy nami c benef i
ts accr ue t o dev el
oped nat i
ons,l eav i
ng
devel oped nat ions poor ,undev eloped and dependent .Thi s bel iefi sr ei
nf orced by t he
obser vat iont hatal ldev elopednat ionsarepr imar i
lyindust ri
alwhi leal ldev el
opingnat i
onsar e
primar ilyagr icultural.Thusdev elopingnat ionsat tackt raditionaltr adet heoryascompl et
ely
staticandi rrelevantt ot hedev elopmentpr ocess.Asar esultdev elopingnat i
onsdemand
changesi nt hepat ternoft r
adeandr eform oft hepr esenti nternationaleconomi csy stem to
takei nt oconsi der ationt heirspecialdevelopmentneeds.

Traditi
onaltradetheorycanreadil
ybeext endedtoincorporatechangesinfactorsupplies,
technologyandt astesbythet echni
queofcompar ati
vest ati
cs.Thismayindicatethata
nation’
spat t
ernofdevel
opmentisnotdeterminedonceandf orall,
butmustberecomputedas
under l
yi
ngconditi
onschangeorisexpectedtochangeov ert
ime.Therefor
edevelopi
ngnations
arenotnecessar i
lyoralwaysrelegat
edbyt radi
ti
onaltradet heoryt
oexportmostlypri
mar y
commodi t
iesandimportmostl
ymanuf actur
edproducts.

Thecont
ri
but
ionoft
radet
odev
elopment

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page28
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Besidethestat
icgai
nfr
om comparat
iveadvant
age,bywhichi tcancont
ri
but
et otheeconomic
developmentdevel
opi
ngnati
ons,t
herearei
mportantbenefi
cialeff
ectst
hati
nternat
ionalt
rade
canhav eoneconomicdev
elopment.

 Tradecanl eadt ofull

uti
li
zationofunder empl oy eddomest i
cresources.
 Byexpandi ng thesizeoft hemar ket,trademakespossi bledi v
ision ofl aborand
economi esofscal e.Thisi sspeci all
yi mport antandhasact uall
yt akenpl aceinthe
productionofl i
ghtmanuf actur
esi nsuchsmal leconomi cunit
sasTai wan,HongKong,
andSi ngapore.
 Int
ernationaltr
adei savehicleforthetransmi ssionofnewi deas,newt echnologi
esand
newmanager i
alandotherskill
s.
 Tradeal sostimulatesandf aci
li
tatesthei nter
nat ionalf
lowofcapi t
alfr om devel
opedto
developingnations.
 Inseverallargedevelopi
ngnat i
ons, theimpor tationofnewmanuf act
ur edproductshas
sti
mul ateddomest icdemandunt i
leffi
cientdomest icpr
oducti
onoft hesegoods
becomepossi ble.

Dev
elopmentSt
rat
egyt
hroughI
mpor
tSubst
it
uti
onv
ersusExpor
ts

Dur i
ngthepastdecades,mostdevel
opi
ngnat
ionsmadeadeli
berat
eat
tempttoindust
ri
ali
ze
rathert
hanconti
nuinginspeci
ali
zi
nginthepr
oduct
ionofpr
imar
ycommodit
iesforexport
,as
prescri
bedbytr
adit
ionalt
radet
heory.

Thedesireofdev el
opingnati
onst oi
ndustr
iali
zeisnaturali
nvi
ewoft hefactthatal
ldeveloped
nati
ons arei ndustr
ialwhile al
ldev el
opi
ng nati
ons pr i
mari
l
yagr ari
an.Hav ing deci
ded to
i
ndustri
ali
ze,dev el
oping nati
onshad t o choose between i
mportsubstitut
ion and export
-
ori
entedindustri
ali
zati
on.Bothpoli
cieshaveadvant
agesanddi sadv
antages.

Industr
iali
zat
ionthr
oughimportsubstit
uti
on:isawayofpr omoti
ngdomestici
ndustr
ial
i
zat
ion,
parti
cularl
yinconsumergoodst hr
oughimportrestr
ict
ion,sothatdomesti
cmarketis
preservedfordomesti
cproducts,whichcanthustakeovermarketsal
readyest
abl
ishedint
he
country.Themainadvantagesofthispoli
cyarethefol
lowing:

 Themar ketfori ndustr

ialpr
oductsal r
eadyexist
s,asevi
dencedbyimpor tsofthe
commodi ty,sot hatri
sksarereducedi nsetti
ngupanindustr
ytoreplaceimpor t
s.
 Iti
seasierfordev el
opingnati
onst oprotectt
heirdomest
icmarketagainstforei
gn
competi
t i
ont hant oforcedevelopednat i
onstolowert
radebarr
ier
sagai nstthei
r
manufacturedexpor t
s.
 Forei
gnfirmsar einducedtoestablishtari
fff
actori
est
oov er
comethet ari
ffwallof
devel
opingnat ions.

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page29
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Agai
nstt
hoseadv
ant
ages,
ther
ear
ethef
oll
owi
ngdi
sadv
ant
ages.

 Domest i
cindustri
esgrowaccust omedt oprotectionfr
om forei
gncompl eti
onandhav e
noi ncenti
vetobecomemor eeffici
ent
 Impor tsubstituti
on leads t
oi neffi
cientindust ri
es because the smallness ofthe
domest i
cmar ket,
whichdoesnotal l
owt otakeadv ant
ageofeconomi esofscale.
 Afterthesimpl ermanufact
uredimpor t
sarer eplacedbydomest i
cpr oducti
on,import
subst i
tuti
onbecomesmor ediff
icul
tandcost lyasmor ecapitali
ncentiv
eand
technological
lyadvancedimportshav etober eplacedbydomest i
cpr oduct
ion.

Themai
nadv
ant
agesofexpor
tpr
omot
ionar
ethef
oll
owi
ng:

 Itov er
comest hesmallnessofdomest icmar ketandal l
owsadev el
opi
ngnat i
ont otake
adv antageofeconomi esofscal e.Thisi sparti
cularl
yimportantf
ormanydev elopi
ng
nationst hatareverypoorandsmal l
.
 Product i
onofmanuf acturedgoodsf orexpor trequiresandsti
mulat
eseffi
ciency
throughoutt heeconomy .Thi
sisspeci allyimportantwhentheoutputofanindustryis
usedasani nputbyanotherindustryint heeconomy .
 Theexpansi onofmanuf acturedexport sisnotlimited(asinthecaseofimpor t
subst i
tution)bythegrowt hofthedomest i
cmar ket.

Thet
woser
iousdi
sadv
ant
agesofexpor
tpr
omot
ionasapol
i
cyar
e:

 Itmaybeverydi
ffi
cultfordevel
opi
ngnat i
ontosetupexpor ti
ngindustr
iesbecauseof
thecompeti
ti
onfrom themor eest
abli
shedandeffi
cientindustr
iesindevel
opednations.
 Devel
opednati
onsof t
enpr ov
ideahighlevel
ofprotecti
onf ort
heirsi
mpl el
abor-
i
ntensi
vecommodi t
iesinwhichdevelopi
ngnati
onsal r
eadyhav eorcansoonacqui r
ea
comparat
iveadvant
age.

CHAPTERFOUR:THEORYOFTRADEPROTECTI
ON

Hav
eyouev
erhear
doff
reet
radeandpr
otect
ion?Whatdoy
ouunder
standabouti
t?

4.
1.Conceptandar
gument
sofPr
otect
ioni
sm

Prot
ecti
on impl
ies gr
anti
ng a prot
ecti
ve cov
ertot he home indust
ri
es agai nstfor
eign
competit
ionei
therbyi mposi
ng dut
iesont hefor
eigngoodsorbyhel ping t
hedomest i
c
i
ndustr
iesbygiv
ingsubsi
diesandmakingrawmater
ial
savai
labl
eatsubsi
dizedprices.

Gener
all
y,pr
otect
ionofi
ndust
ri
esmayi
nvol
ve:

i
)lev
yingofi
mpor
tdut
ieswhi
chmayr
aisepr
iceoff
orei
gngoodsr
elat
ivet
odomest
ic
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page30
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

goods;or
i
i
)f i
xingofquotasorposi ngofnon-tar
if
frest
ri
cti
ons,whichmaket heent
ryofcheap
forei
gngoodsdiff
icul
tori
mpossibl
e;or
i
i
i)granti
ngofsubsidiesorrewar
dtothedomestici
ndustr
iestoenabl
ethem t
ocompete
withcheapfor
eigngoods.

Ar
gument
sinSuppor
tandagai
nstofPr
otect
ionPol
icy

Ar
gument
sinSuppor
tofPr
otect
ionPol
icy

Infantindust
ryar gument:Accordi
ngtot hisargumentindustr
ieswhichar eint heiri
nfancyare
tobepr ot
ectedagainstforei
gncompet i
tionbecauset heyarenotst rongenought ocompet e
wi t
ht hewellestabli
shedforei
gnindustries.Themai nideabehindt hisargumenti sthatfree
tradeamongunequali snotatalldesi
rable.Thear gumentisbasedont hefactt hatt
hei nf
ant
i
ndust ryisnoti napositi
ont oreal
izeinternalandexternaleconomi es.Protectionhelpsthe
i
nf antindust
ryt ogrow upt oitsopti
mum l ev
elandt oreducecost sbygr owingacadr eof
skill
edlaborforceorbyspreadingknowledgeofpr oducti
ontechniques.

Diversi
fi
cati
onofI ndustr
iesAr gument :Pr
otectionhel psint hediversif
icati
onofi ndustri
esi n
acountry.From thepoli
ti
calpoi ntofviewinterna¬tionalspeciali
zationisdanger ousbecause
i
tmakest hecount ryt
oomuchdependentonf orei
gnt radewhi chi sr i
skyandundesi rable
parti
cul
arl
yduringwart i
me.Fr om theeconomi cpoi ntofv iewdependenceonaf ewi ndustries
mayl eadt oser i
ouseco¬nomi cconsequenceswhensuchi ndust ri
espasst hroughr ough
weather.Hence,i tisnecessar yt hatforat t
aining nationalself-suffi
ciencyand bal anced
economicgrowt h,thei
ndustr
iesshoul dbediversifi
edwi tht hehel
pofapol i
cyofprotecti
on.

Employ
mentAr
gument:Apolicyofpr
otect
ionst
imul
ateseconomi
cact
iv¬i
tyandr
aisest
he
l
evel
ofempl
oymenti
nthecountr
y.

TermsofTr adeArgument :I
tisheldthatprot
ecti
onimprovesacountry'stermsoft r
adeand
enablesittosecurelar
gergainsfrom i
nter
nati
onalt
rade.I
mpo¬sit
ionoft ar
iff
sraisesthepri
ce
ofimpor t
sinthecountrythatimposestari
ff
s.Thi
smakest hedemandf orimportstofall
which
compel stheproducersintheexport
ingcountr
ytolowerthepri
ceoftheirproductsandreduce
theforei
gnsupplytomat chthereduceddemandi nthecount
ryimposi
ngt ari
ffs.

Bargai
ningArgument:Thepr otagoni
stsofpr ot
ectionarguet hati
tincr
easesthebargai
ning
powerofthecountryinint
ernati
onaltr
ade.Itmeanst hatiftar
iff
sareimposedbyacountry,i
t
canforceothercountri
estol owertheirt
ari
ffdutiesandt husenablethatcount
rytoobtain
fav
orablet
ermsforitsexport
sf r
om othercountr
ies.

BalanceofPaymentsArguments:I
tishel
dthatpr
otecti
onhel
psthecoun¬t
ri
esi
nr emov
ing
thedisequi
l
ibr
ium i
ntheirbal
anceofpayments.I
nor dert
ocor¬rectt
heimbal
anceinthe
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page31
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

bal
anceofpaymentacountr
ybyimposingtar
if
fscanhav
eanexcessofexpor
tsov
eri
mpor
ts
andwil
lthusear
nmorefor
eignexchange.

Anti
-Dumping Argument:Dumping means thatthe f
orei
gn count
rydumps t he domesti
c
marketwithi
tsgoodsatav er
ylowpri
ce,evenlowert
hanwhatthatcount
ryreceiv
esinitsown
market.Consequent
ly,dumpi
ngi sdetr
imentaltoacountryi
nwhi chitoccurs.Itrui
nsthe
competingfi
rmsintheimport
ercount
ry.

RevenueAr gument:I
tisheldthatprot
ecti
onisagooddevi
cefori
ncr
eas¬ingrevenuesofthe
government.Inthefir
stplace,imposi
tionoftar
if
fpr
otect
sthehomei ndust
riesaswel las
bri
ngsrevenuetothegovernment.

Capit
alFormat
ionArgument :
Prot
ecti
oncanal sol
eadtothepromoti
onofcapit
alfor
mationby
i
ncreasi
ngthesavi
ngr at
iointhecount
ry.Incr
easeintari
ffmayincr
easet
hedomest icsavi
ng
rat
ioby:pr
ovi
dingbet
tertermsoftr
ade,att
ract
ingfor
eigninv
estment,
andbyincr
easi
ngsav i
ng
t
hroughacutinconsumpt i
on.

Self
-suf
fici
encyArgument:Thisar gumenthasbeenadvancedinfavorofprotect
ionasa
sourceofattai
nmentofnationalself
-suf
fi
ciencyandf
orpr
ovidi
ngprotect
iont
ot hecount
ry
fr
om outsidedi
stur
bances.

BasicIndust
ryArgument:Poweri
sessent
ialf
ort
hedevel
opmentofbasi
candkeyi
ndust
ri
es
l
ikeironandst eel
.Protect
ioncanhelpinthedev
elopmentofsuchindust
ri
esandthus
promoteindust
ri
ali
zat
ion.

Maintaini
ngHighWageArgument ;Apoli
cyofpr ot
ect
ionhasbeenadvo¬cat
edt
oprotectthe
i
nterestofthedomest
icworkers.Itishel
dt hatcompeti
ti
onfr
om ahighwagecount
rywi t
ha
l
ow wagecount r
ywil
lcreatepr oblemstobot ht hecount
ri
es.Butapol i
cyofprotect
ion
enablesthehi
ghwagecountri
est ocompet ewiththel
owwagecountri
es.

DefenseAr gument:
Protect
ionisnecessaryforthedevel
opmentofnat i
onaldefenseindust
ri
es
part
icular
lyformeeti
ngwart i
mesi tuati
ons.Infactnati
onalsecuri
tyandmai ntenanceofthe
sanctit
yofnat i
onalfronti
ersaremor eimpor t
antthan economicpr osper
it
yoreconomi c
development.EvenAdam Smithsaidthatdefenseisbett
erthanopulence.

Nati
onali
stArgument:Prot
ect
ioncr
eat
esaspi
ri
tofnati
onal
i
sm andpatr
io¬t
ism i
nthepeople,
and st
imulat
es the dev
elopmentofdomest
icindust
ri
es byre¬st
ri
cti
ng import
sthrough
prot
ect
ivemeasures.

Preser
vati
onArgument:Pr
otect
ionisalsosuppor
tedforthepreser
vat
ionofpart
icul
argroups
ofpeopleandpart
icul
aroccupati
ons.Forexample,i
nunder¬dev el
opedcountr
ieslikeIndi
a
agri
cul
tur
ef or
msthebackboneoft hesocietyand,t
herefor
e,bylevyi
ngtar
if
fdut i
esont he
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page32
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

i
mpor
tofcheapf
oodgr
ains,
mai
nlyf
orpr
otect
ingt
heagr
icul
tur
ist
s,woul
dbej
ust
if
ied.

Ar
gument
sagai
nstPr
otect
ion

 LossofRev enue.Thei mposi tionofpr otect ivet ariff

sr educesi mpor t
sandconsequent l
y
the r evenueoft hegov ernmentf r
om cust omsdut iesdecl i
nes.
 Uneconomi c Use ofResour ces.Si nce pr ot ection mayl ead t ot he dev elop¬mentof
economi callyl essef fi
cienti ndust ries,t her esour ceswoul d bet ransferred from mor e
product i
v euset olesspr oduct iveuse.
 Prev ent sI ndust ri
alGrowt h.Pr otect iononcegr ant edcannotbeeasi lywi t
h¬dr awnbecause
ofv est edi nterests.Prot ect ioni nf actbecomesaper manentf eat ureandt hepr ot ected
i
ndust rycont inuestoremai nani nf anti ndust ry. .
 Producer sbecomeLet har gi c.Theabsenceofcompet it
ionowi ngt ot headopt i
onofpol i
cy
ofpr otect i
onmakest hehomepr oducer sl ethar gic.Theydonotcar et oi mpr ovet heir
effi
ciencyorr educethecostoft hei rpr oduct ion.
 No I ncr ease i nt he Lev elofEmpl oy ment .Pr otection mayal so notl ead t o gener ate
empl oy mentbecausewhat ev erj obswi l
lbecr eatedi nt hepr otecteddomest i
cindust ri
es
willbebal ancedbyaf allint heempl oy menti nexpor ti
ndust ri
es.
 Losst oConsumer s.Pr otect ionl eadst or estr i
cti mpor tsandi ncr easedo¬mest icpr ices
andul ti
mat elymakest heconsumer st osuf fer .
 UnequalDi stributi
onofI ncome.Pr ot ecti
onmakest her i
ch,richerandpoor ;poor er.The
ri
chenj oyl ar gerbenefitsandt hepoorsuf ferbecauseofi ncreasei npr ices.Thuspr otect i
on
aggrav atesi nequal i
ti
esi nt hedi stribut ionofweal th..
 Creat ion ofMonopol ies.I mposi ti
on oft ariffl eads t ot he gr owt h ofmo¬nopol isti
c
tendenci es.Si ncet hereisnof or eigncompet i
tion,domest icproducer senj oymonopol isti
c
gainsbyear ninghighpr ofits.
 TariffWar s.Byi mposingpr otect ivet ar i
ff
sacount ryforcesot hert radingpar tnersal sot o
i
mposet ar i
ffsont hei
ri mpor tsasar etaliator ymeasur e.Thi sul t
i¬mat elyr esult
si nt ariff
war .

4.
2.MeansofTr
adeRest
ri
cti
on

Meani
ngandTy
pesofTar
if
fs

Tarif
freferst oataxordutylev
iedbyt hegov ernmentofacountryongoodsandser vices
enter¬i
ngf orei
gntrade.Whenadut yi
si mposedonacommodi tyatthet
imeofitsleav¬ing
thenationalborder,i
tiscal
led'
exportduty'andwheni ti
slevi
edont hegoodsenteri
ngt he
nati
onal border,
iti
scall
ed'i
mportduty
'.Therearefourt
ypesoft
arif
fs.

 Speci fi
cDuty.Iti safixedsum ofmoneyimposedasadut yonacom¬modity
accor
dingtoit
swei ghtormeasur
ement(
physi
caldi
mensi
ons)asBi
rr
.Xperuni
torper
meterorperl
i
ter,
etc.
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page33
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

 Ad v al
orem Dut y.Itisimposed asa percent
ageoft hevalueoft heim¬port
ed
commodit
y.Thev alueisincl
usi
veofinsur
anceplusfrei
ghtcharges,thati
s,costoft
he
commodit
yplusinsuranceandfrei
ghtchar
ges,repr
esentthetot
alv al
ueofacommodi t
y
onwhi
ch,thedut
yi scharged.

 CompoundDut y.Acombi nat

ionofbothspeci
fi
candadv alor
em dut
iesisacompound
dutyl
evi
edonacommodi t
y.
 Sl i
dingScaleDuty.Itislevi
edont hebasi
soft hepr i
ceoft heimportedcommodit
y
ri
si
ngandf al
l
ingwit
hani ncr
easeordecreasei
ntheprice.Itcanbespecif
icoradval
orem
butmostl
yiti
sspecif
ic.

Meani
ngandTy
pesofQuot
as

Quotasareadeviceunderwhi
chli
mitisf
ixedinr
espectofei
therthev al
ueorthequant
it
yofa
commoditythatmaybei mpor
tedorexportedbyacountryduri
ngaspeci f
iedperi
odoftime,
usual
lyoney ear
.Thepr i
meobjecti
veisthequickandef f
ecti
ver egul
ati
onofi mpor
tsand
export
s.

I
mportquotasar eoftenusedtoprotect
:i)domest
ici
ndust
ri
esf r
om f
orei
gncompet
iti
on;ori
i)
t
ocorrectadisequil
ibri
um int
hebalanceofpay ment
s;ori
i
i)forcommerci
albar
gai
ning;ori
v)
t
oexecutebarterdealswit
hdiff
erentcountr
ies.

Expor
tquotasmaybeusedf or(i)equi
tabl
edist
ri
buti
onofscar ceexpor
t,i
i)regul
ati
onof
expor
tsofessent
ial
rawmat
eri
als;
orii
i)t
oex¬ecut
eint
ernat
ional
exportagr
eements.

Acount
rymayusedi
ff
erentt
ypesofquot
as,
whi
chi
ncl
udes:

 Tar i
ffQuot as:Undert hissystem acount rymayal l
owt hei mportsofaspecifi
edquant ity
ofacommodi tyeitherdut yfr
eeoratav er
ylowdut y.Beyondt hi
slimitahighrateofdut yis
charged.
 Uni l
ateralQuot as:Undert hisacount r
ymayuni l
ateral
l
yf ixaquant it
yorv al
ueofa
commodi tyeithert hroughlegislati
onorbydecr eet hatcanbei mported.Iti
sgl obalifa
specifi
ccommodi t
ycanbei mpor tedf r
om anypar tofthewor l
d.
 BilateralQuot as:Whent hequot asar efi
xedbymut ualagreementbet weenthecount ri
es,
i
tisknownasbi lateralquotasy stem.Suchasy stem wor ksmor esmoot hlyt hant he
unil
ateralquotasy st em.
 Mi xi
ngQuot as:Whent hedomest icproducersar emadet ouset heimportedrawmat erial
i
naf ixedpr oportionwi thdomest icraw mat eri
alint heproducti
onofacommodi tyand
quotasf orthei mpor tofspecifi
edr awmat er
ialarefi
xedont hisbasisthequotasar ecalled
'
mixingquot as'.

Meani
ngandt
ypesofSubsi
dies
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page34
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Nati
onalgover
nmentssometi
mesgrantsubsi
diestot heirproducerstohelpimpr ovetheir
t
radeposi
ti
on.Byprov
idi
ngdomest
icfi
rmsacostadv antage,asubsidyal
lowsthem tomar ket
t
heirpr
oduct
satpri
ceslowert
hanwar
rant
edbytheiractualcostorprofi
tconsi
derat
ions.

Theretwotypesofsubsi es:adomest
di icsubsidy,whichi
ssometi
mesgr
antedtoproducers
ofimport
-competi
ngindust
resandanexpor
i tsubsidy,whi
chgoest
opr
oducersofgoodsthat
aretobesoldover
seas.

CHAPTERFI
VE:ECONOMI
CINTEGRATI
ON

Ethi
opiaasoftoday,i
snotamemberofRegi onalTr
adingArrangementFr eeTradeAreaAfr
ica
hasdoneonlya10per centreduct
ionoft ar
ifffort
hegoodscomi ngfrom COMESAmember
stat
est obewareoff earoflossofpubl icrevenueast ar
if
fr evenueist hemostsigni
fi
cant
sourceofgovernmentrevenueandt hepotenti
aldamaget oitsweaki nfanti
ndust
ri
esandlow
degreeofdomesticfi
rms’competit
iveness.WhatRegionalTradingArrangementmean?

5.
1.Ty
pesofr
egi
onalt
radi
ngar
rangement
s

Economicintegr
ati
oni saprocessofeliminati
ngrestr
ict
ionsoni nter
nat
ionalt
rade,pay
ments
andfactormobili
ty.Economicintegr
ati
ont husresul
tsintheunit i
ngoftwoormor enati
onal
economies i
nar egionaltradi
ng arr
angement .There are di
ff
erentdegrees ofeconomic
i
ntegrat
ion (
regi
onalt radi
ng arr
angement s)
.Below aret he differ
enttypes ofeconomic
i
ntegrat
ion.

1.Free-t radear ea.Thi si sanassoci ati

onoft r
adingnat ionswhosemember sagr eeto
remov e al lt arif
fand non-t ariffbar r
iersamong t hemsel v
es.Each member ,howev er,
mai ntai
nsi tsownsetoft r
ader estr
icti
onsagai nstoutsiders.Anexampl eoft hi
sst ageof
i
ntegr ati
oni st heNor thAmer icanFr eeTr adeAgr eement( NAFTA) ,consistingofCanada,
Mexi coandt heUS.
2.Cust omsUni on.Asecondst agei nthepr ocessofeconomi cintegrationisthef ormat i
onof
customsuni on.Li keaf reetradeassoci at i
on,acust om unioni sanagr eementamongt wo
ormor et rading par tnerst or emov e allt ari
ffand non-t ari
fft r
ade bar ri
ers among
themsel ves.I naddi ti
on,howev er,eachmembernat ionimposesi dent icaltr
ader estri
cti
ons
againstnonpar t
icipants.Thati s,eachnat i
onf oll
owsacommonext ernaltradepol i
cy.The
effectoft hecommonext er
nalt radepol icyist opermitfreetradewi thinthecust omsuni on,
whi l
eall t
rader estricti
onsi mposedagai nstout si
ders(non-member s)ar eequal i
zed.
3.CommonMar ket.Af ur t
herst agei nt hepr ocessofeconomi cintegr at
ioni sacommon
mar ket.Acommonmar ketisagr oupoft r
adingnat i
onsthatper mits;

1)Thef
reemov ement
sofgoodsandser vi
cesamongmembernat ions
2)Thei
nit
iat
ionofcommonexternal
traderest
ri
cti
onsagai
nstnonmembersand
3)Thef
reemov ementoff
actorsofproducti
onacrossnat
ionalborder
swi
thi
nthe
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page35
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

economi
cbl
oc(
group)
.

Thecommonmar ketthusrepr
esentsamorecomplet
estageofintegr
ati
ont
hanaf
ree-
trade
areaorcust
omsunion.TheEuropeanUni
on(EU)achi
evedt
hestatusofacommonmarketin
1992.

4.Economi
cUni
on

Thi
srepr
esent
sanev
enf
urt
herst
epi
neconomi
cint
egr
ati
ont
hanacommonmar
ket
.

I
naddi ti
ont opermitt
ingfreemov ementofgoods,ser v
icesandf actorsofpr oducti
on,and
foll
owingacommonext ernaltr
adepoli
cyagai nstnonmember s,nati
onal,social
,taxat
ionand
fi
scalpoli
ciesar eharmonizedandadmi nist
eredbyasupr anat
ionalinsti
tuti
onineconomi c
union.Inot herwords,inadditionto aboli
ti
onofexi sti
ngt r
adebar ri
ers,economi cunion
requir
esanagr eementtotransf
ereconomicsov erei
gnt
ytoasupernat alauthori
ty.

5.Monet
aryUni
on

Thisrepresentstheul ti
matedegreeofeconomi cuni
onanditrequirest
heuni f
icati
onof
nati
onalmonet ar
ypol ici
esandt heacceptanceofacommoncur rencyadminist
eredbya
supranati
onalmonet ar
yauthori
ty.TheU.S.serv
esasanexampl
eofamonet aryunion.Fi
ft
y
stat
esar eli
nkedt oget
herinacompl et
emonet aryuni
onwi
thacommoncur rency,i
mplyi
ng
completel
yfixedexchangeratesamong50st at
es.

5.
2.Reasonsf
orRegi
onal
ism

Amot i
vati
onofv i
rt
ual
l
yev eryregionaltradingar r
angementhasbeent hegoalofenhanced
economi c gr
owt h.An expanded r egionalmar ketcan all
ow economi es ofl
arge scal
e
producti
on,fosterspecial
izat
ionand l earning-by–doi ng,and at
tr
actf or
eigni
nvest
ment .
Regionalini
ti
ati
vescanal sofosterav arietyofnoneconomi cobjecti
ves,suchasmanaging
i
mmi gr
ati
onflowsandpr omotingregionalsecurit
y .

Moreov er
,small
ernat
ionsmayseeksaf e-hav
ent radi
ngar r
angementwithlar
gernati
onswhen
fut
ure access t
ot he largernat
ions’markets appears uncert
ain.Thi
s was an apparent
motivati
onfort
heformat i
onofNAFTA.InNorthAmer i
ca,Mexicowasmot i
vat
edtojoinNAFTA
part
iall
ybyfearofchangesi nt
heU.Stradepoli
cyt owardsamor emanagedorst r
ategi
ctr
ade
rel
ati
on.

Fur
ther
mor e,
asnewr egi
onaltr
adingarr
angement sareformedorexi sti
ngonesareexpanded
ordeepened,the opport
uni
tycostofr emai ni
ng outsi
de an ar r
angementincreases.Non
memberexpor t
erscoul
dreal
izecostl
ydecreasesinmar ketshareifthei
rsal
esaredi v
ert
edt o
companiesofthemembernat i
ons.Thi
sprospectmaybesuf fi
cienttoti
pthepoli
ti
calbalance
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page36
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

i
nfavorofbecomingamemberofaregi
onaltr
adingarr
angement
,asexpor
ti
ngi
nter
estofa
nonmembernati
onoutwei
ghti
tsi
mportcompeti
ngint
erest
s.

3.Ef
5. fect
sofar
egi
onalt
radi
ngAr
rangement

I
nt hissection,wewi l
lseethetheoreti
calbenef
it
sandcost sofcust
omsunionfr
om two
perspect
ives:stati
canddynamic.First
,let
’sseethestat
iceffect
sofeconomi
cint
egr
ati
on
(customsuni on)onpr
oduct
iveef
fi
ciencyandconsumerwelf
are.

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page37
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

St
ati
cef
fect
s

Tounderst
andthestati
cwelfar
eef
fect
sofcust
omsuni
on,
assumeawor
ldcomposedoft
hree
count
ri
es:Luxembourg,Ger
manyandU.S.

Supposet hatLuxembourgandGer manydeci

detoform acustomsunion,andtheU.S.i
sanon
member .Thedeci si
ont
of orm acust
om uni
onrequir
esthatLuxembourgandGer manyaboli
sh
al
ltar
iffrestr
ict
ionsbet
weent hemselveswhi
lemaintai
ningacommont ar
if
fpoli
cyagainstt
he
US.Ref err
ingtothefol
l
owi ngfi
gure,
assumethestati
cwelfar
eeffectofacust
omsuni on.

Pr
ice(
$) SL

SG+
3.
7 t
ari
ff
5
SUS+tariff
C
a
SG

SU

DL
Grain
1 4 7 17 (bushel
s
)

Fi
gur
e5.
1St
ati
cWel
far
eEf
fect
sofacust
omsUni
on

Thef ormat i
onofcust omsunionleadst oawel
far
e-incr ngt
easi r
ade-creati
oneffectanda
welfare-decr ng t
easi rade-di
ver
sioneffect
.Theoveral
leffectoft hecustomsunionont he
welfareofi t
smember s,aswellasontheworl
dasawhol e,dependsonther el
ati
vestr
engthof
theset woopposi ngf
orces.

Suppl
y and demand schedules ofLuxembour
gto be S¬¬L and DL. Assume al
so t
hat
Luxembour
gisver
ysmal l
relat
ivetoGer
manyandtot
heU.S.

ThismeansthatLuxembourgcannotinf
luencef
orei
gnprices,sothatf
oreignsuppl
yschedul
es
ofgrai
nareperf
ectl
yelast
ic.LetGer
many ’
ssupplypr
icebe$3. 25perbushelandthatofUS$3
perbushel
.NotethattheUSi sassumedt obethemor eef f
ici
entsuppl
ierasitcanoffert
he
grai
natalowerpri
ce.

1.Befor
ethef or
mati
onoft hecustomsunion(andundert
hecondi
ti
onsoffreetrade)
,
Luxembour
gf i
ndsitadv
antageoustopur
chaseallofi
tsi
mpor
trequi
rement
sfrom the
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page38
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

UnitedSt ates.Ger manydoesn’ tpart

ici
patei nt hemar ketbecausei tssupplypri
ceexceeds
thatoftheUS.I nf ree–t radeequili
bri
um, Luxembour g’ sconsumpt ionequals23bushels,
productionequal s1bushel ,andimportsequal 22bushel s.
2. Now supposeLuxembour glevi
esat ari
ff50cent soneachbusheli mport
edf r
om the
UnitedSt ates( orGer many).Thisraisest heGer many ’ssuppl ypriceto$3. 75andt he
UnitedSt atessuppl ypri
cet o$3. 5st i
ll
,Luxembour gwi l
lfi
ndi tadv ant
ageoustoimpor t
from US.Butsi ncet heimposedt ari
ffhasi ncr easedt heprice,Luxembour gimport
sless
bushelsofgr ai
n( thelevelofimportdecreasesf rom 22bushel st o10bushels)
3.Nowsupposet hat,aspar tofat r
adel i
berali
zat ionagreement ,Luxembour gandGer many
form acust omsuni on.Luxembour g’
si mpor tt ari
ffagainstGer manyi sdropped,buti
tis
stil
lmaint ainedoni mportsf r
om thenonmemberuni tedst ates.ThismakesGer manya
low-pricesuppl i
erandLuxembour gnow pur chasesal lofitsi mpor t
s(16bushels)fr
om
Germanyat$3. 25perbushel ,whi l
ei mpor tingnot hingfrom t heUS.Themov ement
towardsf reet r
adeunderacust omsuni onaf fect sworldwel f
arei ntwoopposingway s:

- Awel
far
e–i
ncr ngt
easi rade-cr
eati
oneff
ectand
- Awel
far
e–r ngt
educi r
ade–di ver
sionef
fect

Theover
allconsequenceofacust
omsuni ononthewel
far
eofit
smembers,aswellasont
he
worl
dasawhol e,dependsont
herelat
ivestr
engt
hsoft
hesetwoopposi
ngf
orces.

Todisti
ngui
sht
hewel f
areef
fect
sofcust
omsunion,wecompar etheequi
li
bri
um condi
ti
on
aft
erthefor
mat
ionofcust
omsunionwi
tht
heequi
l
ibri
um condi
ti
onbefor
eformati
oncustoms
uni
onwhenLuxembourghasi
mposedauni
for
mtari
ffonbothU.SandGermany.

Tradecr eati
onoccur swhensomedomest i
cpr oducti
onofonecust oms–uni onmemberi s
replacedbyanot hermember ’
sl ower-costimpor ts.Inourexampl e,trade-cr eati
onoccur s
whent heLuxembour g’sdomest icproduct
ionofgr ai
nisreplacedbytheGer many ’
slower -cost
i
mpor t
s.Thati s,bef orethef ormat i
onofcust omsunionLuxembour gusedt opr oduce7
bushelsofgr ai
n,whi leimpor t
ing10bushel sf rom US.Aftertheformat i
onofcust omsuni on
agreementwi t
hGer many ,Luxembour gcannow i mportgrainat$ 3. 25 perbushel .Thi s
reducesdomest i
cpr oductionf r
om 7bushel st o4bushel sinLuxembour g.Hence,cust oms
unionagr eementbet weenGer manyandLuxembour ghast heeffectofi ncreasedpr oduction
speciali
zati
oninGer manyaccor dingtotheprincipl
eofcompar ati
veadv antage.Thisincreases
thewel f
areofbot hcount r
ies:Luxembour gconsumer sarenowpay i
ngal owerpr ice($3.25per
bushel)thanbef ore($3.5perbushel )andGer many ’
sproducershavenow gott hechancet o
producemor eandexpor tthei
rpr oduct.

Thet
radecr
eat
ionef
fectconsi
stsofaconsumpt
ionef
fectandapr
oduct
ionef
fect
.

Consumpt
ionef
fect
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page39
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Beforetheformati
onofcustomsuni onandunderi
tsownt ar
if
fumbrell
a,Luxembourgi mports
fr
om theUSatapr i
ceof$3. 50perbushel
.Luxembourg’
sentr
yint
othecustomsuni onr esul
ts
i
ni t
sdr oppi
ngalltar
if
fsagainstGermany.Faci
ngalowerimportpri
ceof$3. 25,Luxembour g
i
ncreasesi t
sconsumpt i
onofgr ai
nby3bushel s(fr
om 17t o20bushels).Thewel far
egai n
associatedwit
hthi
sincreaseinconsumpti
onequalsareaoft
ri
anglebintheabovefigure.

Pr
oduct
ionef
fect

Eli
minatingthet ariffbar r
ieragai
nstGer manymeanst hatLuxembour gpr oducersmustnow
compet eagainstlower -cost ,mor
eeffici
entGermanproducer
s.Ineffi
cientdomest i
cproducers
dropoutoft hemar ket,r
esultingi
nadecl i
neinhomeoutputof3bushel s(from 7to4bushels).
Ther educti
oni nt hecostofobt aini
ngt hi
soutput(t
he3bushel s)equalst r
i esai
angl nt he
fi
gure.Thisarear epr esentst hef
avorabl
eproducti
oneffect
.Theov eralltr
ade-creati
oneffect
i
sgi v
enbyt hesum oft r
ianglesa+b.

Al
thoughacustomsuni onmayaddt
othewor l
dwel
far
ebywayoft
radecr
eat
ion,i
tst
rade
di
versi
onef
fectgener
all
yimpl
i
esawel
far
eloss.

Tradediv
ersi
onoccurswheni mportsfrom alow costsuppli
eroutsi
det heuni
on( U.
S)are
repl
acedbypurchasesf
rom ahighercostsuppl
ierwit
hintheunion(Ger
many )
.Thissuggest
s
thatworl
d product
ioni
sr eor
ganized l
esseffi
cient
ly.Thisi
s,ar eac,thewelfarelossto
Luxembourgandtheworl
dasawhol e.

General
lyspeaki
ng,ourstati
canalysi
sconcl
udesthattheformat
ionofacustomsunionwi l
l
i
ncreasethewelfar
eofi t
smember s,aswellastherestoftheworld,i
ftheposi
ti
vetrade-
creat
ioneff
ectmoret hanoffset
sthenegati
vetr
ade-diver
sionef
fect
.Refer
ri
ngtothefi
gure,
thi
soccursifa+bisgr eat
erthanc.

Dy
nami
cef
fect
sofcust
omsuni
on

However,notal
lwelf
areconsequencesofr egionaltr
adi
ngar r
angementsar estat
icinnature.
Theremayalsobedynamicgainsthatinfl
uencemember -nati
ongrowthratesoverthelong-r
un.
Thesedynamicgai
nsstem fr
om thecr eat
ionoflargermarket
sbyt hemov ementtofreertr
ade
undercustomsuni
ons.Thebenef i
tsassociatedwi thacustomsuni on’
sdy namicgainsmay
morethanof f
setanyunfavorabl
est ati
cef f
ects.Thedy namicgainsincludeeconomi esof
scal
e,gr
eat
ercompet
it
ionandast
imul
usofi
nvest
ment
.

Perhapst hemostnot iceabl

eresultofacustomsuni onismarketenlargement .Bei
ngableto
penetr
at ef r
eelyt he domestic market
s ofot hermembernat ions,pr oducers can t
ake
advantageofeconomi esofscalethatwoul
dnothav eoccur
redinsmal lermarketslimi
tedby
tr
ader est
r i
cti
ons.Largermarketsmaypermiteff
icienci
esatt
ri
butabletogr eat
erspecial
i
zati
on

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page40
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

ofworker
sandmachi
ner
y,t
heuseofmostef
fi
cientequi
pment
,andt
hemor
ecompl
eteuseof
by-pr
oducts.

CHAPTERSI
X:BALANCEOFPAYMENT,
DIS-
EQUI
LIBRI
UM ANDADJUSTMENT

SupposethegovernoroftheNati
onalBankofEthiopi
aannouncesinhispressconf
erencet
hat
theobject
iveofnati
onalmacroeconomicpol
icyistoreducebalanceofpayment(BoP)def
ici
t
anddisequil
i
bri
a.Couldyoudefi
nebalanceofpayment?

6.
1.Bal
anceofpay
ment
saccount
ingandaccount
s

Ani mpor t
antpointaboutacountry
'sbalance-of
-paymentsstati
sti
csisthatinanaccount i
ng
senset heyalwaysbalance.Thi
sisbecausetheyar ebasedupont hepri
ncipleofdouble-
entr
y
book-keeping.Eachtr
ansacti
onbetweenadomest i
candf or
eignresi
denthast wosidestoit
,a
recei
ptand a pay ment,and bot
ht hese sides arerecorded i
nt he balance-
of-
payments
stati
sti
cs.

Eachrecei
ptofcur
rencyfrom r
esident
softher
estoftheworl
disrecor
dedasacredi
tit
em
(apl
usintheaccounts)whil
eeachpaymenttoresi
dentsoft
herestoft
heworl
disrecor
ded
asadebiti
tem (
ami nusintheaccounts)
.

Befor
econsi deri
ngsomeexamplesofhowdi f
ferentt
ypesofeconomi ct r
ansacti
onsbetween
domesticandf orei
gnr
esident
sgetrecordedinthebalanceofpayment s,weneedt oconsi
der
thevari
oussubaccount sthatmakeupt hebalanceofpay ments.Traditi
onal
ly,t
hestati
sti
cs
aredi
videdintotwomainsecti
ons:cur
rentaccountandcapit
alaccount.

A)Cur
rentaccount

Thecur r
entaccountcanbedi videdi ntot wosubaccounts:v i
sibleandi nvi
sibl
eaccounts.The
visi
blesubaccountr ecordsthev aluesofi mportedandexpor tedgoodswher eastheinvi
sibl
e
sub-accountrecordsv al
uesofimpor tedandexpor t
edservices;inter
ests,profi
tsanddivi
dends
receiv
ed;inter
ests,profi
tsanddi videndspai d;unil
ater
alreceiptsandpay ments.Thebalance
ont hevi
sibl
eaccount soft hecurrentaccounti ster
medast hetradebal ancewhereasthesum
ofthev i
sibl
etradebalanceandt hei nv i
sibl
ebalanceister
medast hecurrentaccountbal
ance

Tr
adeBal
ance=Recei
ptsf
orexpor
tedgoods–Pay
ment
soni
mpor
tedgoods

Thet radebalanceissomet i
mesr efer
redt
oast hevisi
blebalancebecauseitr
epresentsthe
dif
ferencebetweenr eceiptsforexport
sofgoodsandexpendi t
ureonimportsofgoodswhi ch
canbev i
sibl
yseencr ossingfront
ier
s.Therecei
ptsf
orexpor t
sar er
ecordedasacr edi
tinthe
balanceofpay ments,whi lethepaymentforimport
si srecor
dedasadebi t
.Whent hetrade
balanceisi nsurpl
ust hi
smeanst hatacountryhasearnedmor ef
rom it
sexport
sofgoods
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page41
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

t
hani
thaspai
dfori
tsi
mpor
tsofgoods.

Cur
rentAccountBal
ance=Tr
adebal
ance+I
nvi
sibl
eBal
ance

Thecur r
entaccountbal anceisthesum ofv isi
bletradebalanceandt heinvisibl
ebal ance.The
i
nvisi
blebal anceshowst hedi f
ferencebet weenr evenuereceivedforexport sofser vi
cesand
payment smadef orimportsofser vi
cessuchasshi ppi
ng,touri
sm,insuranceandbanki ng.In
addit
ion,receiptsandpay mentsofi nter
est,divi
dendsandpr of
itsarerecordedi nthei nvisi
ble
bal
ancebecauset heyrepresenttherewardsf orinvestmentinov er
seascompani es,bondsand
equit
y;whi l
epay mentsrefl
ectt her ewardst oforeignresidentsfortheiri nvest
menti nt he
domest i
ceconomy .Assuch,t heyar ereceiptsandpay ment sfortheser vi
cesofcapi talthat
earnandcostt hecount
ryincomej ustasdoexpor tsandimpor t
s.

Not ethatt hereisani tem r eferr

edtoasuni lat
eraltransferincl
udedi ntheinvisi
blebal ance;
thesear epay ment sorr eceiptsforwhichthereisnocor r
espondingqui dproquo( somet hing
givenorr eceiv
edf orsomet hingelse).Examplesofsucht r
ansactionsaremi grantwor kers'
remittancest ot hei
rf ami l
iesbackhome,t hepay mentofpensi onst oforei
gnr esidents,and
forei
gn ai d.Such r eceipts and pay mentsr epresenta r edist
ri
bution ofincome bet ween
domest icandf oreignr esidents.Unil
ater
alpay ment scanbev i
ewedasaf allindomest i
c
i
ncomeduet opay ment st of orei
gner
sandsoar erecordedasadebi t;whi
leunil
ateralreceipts
canbev iewedasani ncr easeinincomeduet oreceiptsfr
om f or
eignersandconsequent l
yar e
recordedasacr edit.

B)Capi
talaccount

Thecapi talaccountrecor dstransact

ionsconcerni
ngthemov ementoff i
nanci
alcapit
alinto
andoutoft hecountry.Capitalcomesintothecountr
ybybor r
owi ng,sal
esofov er
seasasset s,
andinv estmentinthecount rybyforei
gners.Thesei
temsar ereferr
edtoascapi t
alinf
lowsand
arer ecordedascr edititemsi nthebalanceofpay ments.Capi t
alinfl
owsar e,ineffect,a
decreasei nthecountry'sholdingofforei
gnassetsorincr
easei nli
abil
i
tiestofor
eigners.The
factthatcapi t
alinfl
owsar erecordedascr edi
tsinthebalanceofpay mentsoftenpresents
studentswi t
hdiff
icul
ty.

Capi
talAccountBal
ance=Capi
tal
Inf
lows–Capi
talOutf
lows

Similarl
yinv est
mentbyf oreignr esi
dent sistheexpor tofequi t
yorbonds,whi l
esal esof
overseasi nvestmentsisanexpor toft hoseinvestment stof orei
gners.Conv er
sely,capi
tal
l
eav est hecount r
yduet ol ending,buyingofov erseasasset s,andpur chasesofdomest i
c
asset sownedbyf or
eignresidents.Theseitemsr epresentcapitaloutf
lowsandar er ecor
ded
asdebi tsint hecapit
alaccount .Capit
aloutfl
owsar e,inef fect,anincreasei nthecount r
y'
s
holdingoff orei
gnassetsordecr easeinl i
abil
i
tiestof or
eigners.Theseitemsar erecordedas

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page42
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

debitsast heyr epresentthepur chase,thepur chaseoff orei

gnbondsorequi t
y,andthe
purchaseofi nvestmentsi ntheforeigneconomy .I
temsi nthecapitalaccountar
enormall
y
di
stingui
shed accor ding t
o whethert heyorigi
nat efrom thepr i
vateorpubl i
csector
,and
whethertheyareofashor t
-ter
m orlong-ter
m nature.Thesummat ionofthecapit
ali
nfl
owsand
outfl
owsasr ecordedi nthecapit
alaccountgivesthecapitalaccountbal
ance.

Of
fi
cialset
tl
ement
sbal
ance

Givent hehugest atist

icalpr oblemsinvolvedincompi li
ngt hebalance-
ofpaymentsstatist
ics
therewi llusuall
ybeadi screpancybet weenthesum ofal ltheitemsrecor
dedint hecur r
ent
account ,capitalaccountandt hebal
anceofof f
icialf
inancing(seetable6.
1)whichint heor y
shouldsum t o zero.To ensur ethatt hecreditsanddebi tsar eequali
ti snecessaryt o
i
ncor porateast ati
sticaldiscrepancyforanydi f
ferencebetweent hesum ofcredi
tsanddebi ts.
Therear esev eralpossiblesour cesofthiserr
or.

 Oneoft hemosti mportantist hatiti

sani mpossibl
et askt okeept r
ackofal lthe
tr
ansact i
onsbet weendomest i
candf or
eignr esi
dents;manyoft her eportedstati
stics
arebasedonsampl i
ngest imat esder i
vedf r
om separat esources,sothatsomeer roris
unav oidable.
 Anot herpr obl
em isthatt hedesi retoav oidtaxesmeanst hatsomeoft hetransacti
ons
i
nt hecapi t
alaccountar eunder r
eported.
 Mor eov ersomedi shonestf irmsmaydel i
beratel
yunder -i
nvoicethei
rexpor t
sandov er
i
nvoi cet heiri
mpor t
st oar t
if
iciall
ydef l
atetheirprof
it
s.
 Anot herpr oblem isthatof' l
eadsandl ags'
.Thebal anceofpay ment srecordsr ecei
pts
andpay mentsf orat ransact ionbet weendomest i
candf orei
gnr esidents,buti tcan
happent hatagoodi si mpor tedbutt hepay mentdelay ed.

Thesummat ionoft hecur r

entaccountbal ance,capitalaccountbal anceandt hest at
isti
cal
discr
epancygi v
est heoffici
alset tlementsbal ance.Thebal anceont hisaccountisi mportant
becausei tshowst hemoneyav ai
lablef oraddingtothecount ry'
sofficialr
eservesorpay i
ngof f
thecount ry
'sofficialborr
owi ng.Acent ralbanknor mallyholdsast ockofr eservesmadeupof
forei
gn cur r
encyasset s.Such r eserv esarehel d primari
lyt o enabl ethecent ralbankt o
purchasei t
scur rencyshoul di twi shtopr eventitdepreci
ating.Anyof fici
alsettl
ement sdeficit
hastobecov er
edbyt heauthor it
iesdr awingont hereserves,orborrowi ngmoneyf rom foreign
centralbanksort heIMF( recordedasapl usint heaccounts).If
,ont heot herhand,thereisan
offi
cialsettl
ement ssurplust hent hi
scanber efl
ect
edbyt hegov ernmenti ncreasingofficial
reservesorr epayingdebt stot heI MForot hersourcesov erseas(ami nussincemoneyl eav es
thecount r
y).

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page43
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Thef actthatreserveincreasesar erecor dedasami nus,whi l

er eser vefallsarerecordedasa
plusi nt hebalance-of-
pay ment sstatist
icsi susuall
yasour ceofconf usion.Iti
smosteasi l
y
rati
onal i
zedbyt hinki
ngt hatr eservesi ncreasewhent heaut hori
tieshav ebeenpur chasing
foreigncur r
encybecauset hedomest iccur r
encyisstrong.Thisi mpl iesthatt heotheritemsi n
thebal anceofpay ment sar einsurplus, soreserveincr
easeshav et ober ecordedasadebi tto
ensur eov eral
lbalance.Conv ersely
,r eservesfallwhentheaut horit
ieshav ebeensuppor t
inga
currencyt hatisweak; thatis,al
lotheri t
emssum t oadef i
citsor eser vefallsmustber ecor ded
asapl ustoensur eover al
lbal
ance.

6.
2.Bal
anceofPay
ment
sSur
plusorDef
ici
t

Aswehav eseeni nTabl e6.1,thebal

anceofpay mentsalwaysbal ancessinceeachcr editin
theaccounthasacor respondingdebitel
sewher e.Howev er
,thisdoesnotmeant hateachof
theindi
vidualaccountst hatmakeupt hebalanceofpay ment sisnecessaril
yinbal ance;f or
i
nstance,thecurrentaccountcanbei nsurpluswhi l
et hecapitalaccountisindeficit.When
tal
ki
ngaboutabal ance-of-
paymentsdef i
citorsurpluseconomi stsar ereall
ysayingt hata
subsetofitemsinthebal anceofpay mentsisinsurplusordeficit
.

Economists make a di sti

nct
ion between autonomous (abovet he l
ine items) and
accommodat i
ng (below t he l
i
ne)items.The f ormeraret r
ansactions thattake place
i
ndependently of t
he bal ance of payment
s,whi lstaccommodat i
ng items ar et hose
tr
ansacti
onswhi chfinanceanydi f
ferencebetweenautonomousr eceipt
sorpay ments.A
surpl
usint hebalanceofpay ment
si sdefi
nedasaexcessofaut onomousr eceipt
sav er
autonomous pay ments,whi l
e a defici
tis an excess ofautonomous pay ments over
autonomousreceipt
s.

Aut
onomousr
ecei
pts>aut
onomouspay
ment
s=sur
plus

Aut
onomousr
ecei
pts<aut
onomouspay
ment
s=def
ici
t

Thei ssuet hatt henar i

sesi swhichspeci fi
ci temsi nthebal anceofpay ment sshouldbe
cl
assifiedasaut onomousandwhi chasaccommodat i
ng.Disagreementonwhi chi t
emsqual if
y
asaut onomousl eadst oalternat
iveviewsonwhatconst i
tutesabal ance-of-
pay mentssur pl
us
ordef ici
t.Thedi ff
icultyar i
sesbecausei ti snoteasyt oi denti
fyt hemot i
veunder lyi
nga
tr
ansact ion.Forexampl e,i fther
ei sashor t-ter
m capitali nf
low inr esponset o ahigher
domest i
cinter
estr ate,itshoul dbeclassifi
edanaut onomousi t
em.I f
,howev er,theitem i
san
i
nflow t oenablet hef inancingofi mpor t
st heni tshouldbecl assifi
edasanaccommodat i
ng
i
tem.Thedi ff
icultyofdeci dingwhi chi t
emsshoul dbecl assifi
edasaccommodat i
ngand
autonomoushasl edt osev eralconceptsofbal ance-of
-payment sdisequi
libr
ium.

Al
ter
nat
iveConcept
sofBal
anceofPay
ment
sSur
plusandDef
ici
ts

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page44
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

a)Thet
radeaccountandcur
rentaccount

Theset woaccount sder i

vemuchoft hei ri
mpor tancebecauseest i
matesarepubl i
shedona
mont hlybasisbymostdev elopedcount ri
es.Sincet hecurrentaccountbalancei sconcer ned
withv isibl
eandi nv i
sibl
e,i tisgener all
yconsi deredt obet hemor eimportantoft het wo
account s.Whatr eallymakesacur rentaccountsur plusordef ici
timport
antist hatasur plus
meanst hatthecount r
yasawhol ei sear ni
ngmor ethatinitspendingv i
sa-
visther estoft he
worldandhencei si ncreasingitsstockofcl aimsont herestofthewor l
d;whil
eadef ici
tmeans
thatthecount ryisr educingi tsnetcl aimsont her estofthewor l
d.Furt
hermor e,t
hecur rent
accountcanr eadil
ybei ncorporated into economi canal ysisofanopeneconomy .Mor e
generally,t
hecur rentaccounti slikelyt oquickl
ypi ckupchangesi nothereconomi cv ariables
suchaschangesi nt herealexchanger ate,domest i
candf oreigneconomicgrowt handr el
ative
pri
cei nflat
ion

b)Thebasi
cbal
ance

Thisisthecurrentaccountbal anceplust henetbalanceonlong-term capit

alf
lows.Thebasic
balancewasconsi deredt obepar t
icularl
yi mpor
tantduri
ngt he1950sand1960sper i
odof
fi
xedexchanger atesbecausei twasv i
ewedasbr i
ngingtogetherthestableelementsinthe
balanceofpay ment s.Itwasarguedthatanysi gni
fi
cantchangei nthebasicbalancemustbea
si
gnofaf undament alchangeinthedi rect
ionofthebalanceofpay ments.Themor evol
atil
e
el
ement ssuchasshor t-
ter
m capit
alflowsandchangesi noffi
cialreserveswereregar
dedas
accommodat ingitems.

Althoughawor seni ngoft hebasi cbal ancei ssupposedt o beasi gnofadet eriorati
ng
economi csi tuation,hav i
nganov er
allbasicbal ancedef i
citisnotnecessar il
yabadt hing.For
exampl e,acount r ymayhav eacur r
entaccountdef i
citthati sr einforcedbyal argel ong-ter
m
capitaloutflowsot hatt hebasi cbalancei sinal argedef i
cit.Howev er,thecapi talout f
lowwi ll
yieldfuturepr ofi
t s,dividendsandi nterestreceipt sthatwi llhelpt ogener atef uturesur pluses
ont hecur rentaccount .Conv ersely,asur pl
usi nt hebasi cbal ancei snotnecessar i
lyagood
thing.Acur rentaccountdef i
ci twhichi smor et hancov eredbyanetcapi t
alinflowsot hatthe
basici sinsur pluscoul dbeopent ot woi nt
er pretati
ons.I tmi ghtbear guedt hatbecauset he
count r
yisabl et obor r
owl ongr unt hereisnot hingt owor ryaboutsi ncei tregardedasv iableby
thosef oreignerswhoar epr epar edt olendi tmoneyi nt hel ongr un.Anot heri nterpretati
on
couldar guet hatt hebasi cbal ancesur plusisapr obl
em becauset hel ong-t
erm bor rowi ngwill
l
eadt ofutur einter est,pr ofi
tsanddi videndpay ment swhi chwi llwor sent hecur rentaccount
def i
cit
.Apar tfrom i nter pret
at ion,thepr i
ncipalpr oblem wi tht hebasi cbalanceconcer nsthe
classif
icati
onofshor tt erm andl ong-t
erm capi t
al fl
ows.

Theusualmeansofclassi
fyi
ngl
ong-
ter
ml oansorborr
owingi
sthattheybeofatleast12
mont
hst omatur
it
y.However
,manyl
ong-
ter
m capi
talf
lowscanbeeasi
l
yconver
tedi
ntoshort
-
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page45
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

ter
mf l
owsi fneedbe.Forexampl e,thepur chaseofaf ive-yearUSt reasur ybondbyaUK
i
nvestorwoul dbeclassi
fiedasal ong-t
erm capi taloutflowint heUKbal anceofpay ment sand
l
ong-term capit
ali
nflow i
nt heUSbal anceofpay ment s.Howev er,theUKi nv est
orcoul dv ery
easil
ysellthebondbackt oUSi nvest
or sanyt i
mebef or
ei tsmat uri
tydat e.Simi l
arl
y,many
short-
termitemswithlesst han12mont hst omat urit
yaut omat icall
ygetr enewedsot hatt hey
eff
ectivel
ybecomel ong-t
er m assets.Anotherpr oblem thatbl ursthedisti
nct i
onbet weenshor t
-
ter
m andl ong-
ter
m capi talflowsi sthatt ransacti
onsi nf i
nancialasset sar ecl assifi
edi n
accordancewi t
htheirori
ginalmat uri
tydat e.Hence, ifafterfourandahal fy earsaUKi nvestor
sell
shisfive-
yearUSt r
easur ybil
ltoaUSci t
izenitwillbecl assifi
edasal ong-term capitalfl
ow
eventhought hebondhasonl ysixmont hst omat urit
y.

c)Theof
fi
cialset
tl
ement
sbal
ance

Theof fi
cialset t
lement sbalancef ocusesont heoper at
ionst hatthemonet aryaut hori
ti
eshav e
to under take tof inance any i mbalance i nt he currentand capi talaccount s.Wi tht he
settlement s concept ,t he autonomous i tems ar e allt he currentand capi talaccount
transactions i ncludi ng t he st
atisti
caler ror,whi l
et he accommodat ing it
ems ar et hose
transactionst hatt hemonet ar
yaut hori
tieshav eunder takenasi ndicatedbyt hebal anceof
officialfinancing.Thecur r
entaccountandcapi talaccounti temsar eallregardedasbei ng
i
nducedbyi ndependenthousehol ds,fi
rms,cent ralandl ocalgovernmentandar er egardedas
theaut onomousi tems.I fthesum oft hecur r
entandcapi t
alaccount sisnegative,thecount r
y
canber egar dedasbei ngi ndefi
citast hishast obef inancedbyt heauthorit
iesdr awingon
theirr eser ves off oreign currency,bor rowi ng fr
om f or
eign monet ary authorit
ies ort he
Internati
onal Monet ar yFund.

Amaj orpoi nttonot ewi t

ht heset tl
ement sconcepti sthatcount r
ieswhosecur rencyisusedas
areserveassetcanhav eacombi nedcur r
entandcapi talaccountdef icitandy etmai ntainfixed
pari
tyfort heircur r
encywi thoutr unni ngdownt heirreservesorbor r
owi ngf r
om t heI MF.Thi s
canbet hecasei fforeignaut hori
ti
esel iminatetheexcesssuppl yofthedomest iccurrencyby
purchasi
ngi tandaddi ngitt ot hei
rr eserves.Thisispar t
icul
ar l
yimpor tantfortheUni tedSt ates
si
ncet heUSdol larist hemaj orreser vecurrency.TheUni tedSt at
escanhav eacur rentaccount
andcapi talaccountdef i
citwhi chi sf i
nancedbyi ncreasedf oreignaut horit
ies'purchasesof
dol
larsanddol l
art reasurybi ll
s-i not herwor dsi ncreasedUSl iabi
liti
esconst i
tuti
ngf oreign
authori
ti
es' reserves.Fort hisr easonpar toft heoffici
alset t
lement sbal ancer ecords'changes
i
nliabil
it
iesconst i
tutingfor ei
gnaut horit
ies'reser
ves.'

Theof f
ici
alsett
lementsconceptofasur plusordefici
ti snotasr elevanttocountr
iesthathave
fl
oat i
ngexchanger atesasitistothosewithfixedexchanger ates.Thisisbecauseifexchange
ratesar elefttof l
oatf r
eel
yt heoffi
cialsett
lement sbal ancewi lltendtozer obecauset he
centralauthorit
iesneit
herpurchasenorsel lt
heircurrency ,andsot herewillbenochangesi n
theirreserves.I
fthesalesofacurrencyexceedt hepur chasesthent hecurrencywil
ldepreci
ate,
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page46
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

andi
fsal
esar
elesst
hanpur
chasest
hecur
rencyappr
eci
ates.

Theset
tl
ement
sconceptis,however
,veryimpor
tantunderfi
xedexchangerat
esbecausei
t
showst
heamountofpr
essureontheauthor
it
iest
odevalueorr
eval
uethecurr
ency.

Althoughin1973themaj orindust ri
ali
zedcount ri
esswitchedf rom afixedt ofl
oatingexchange
-rat
esy st
em,manydev el
opi ngcount ri
escont i
nuet opegt heirexchanger atet otheUSdol l
ar
andconsequent l
yattachmuchsi gnif
icancetot hesettl
ement sbalance.I ndeed,totheextent
thatindust
ri
ali
zedcount r
iescont i
nuet oi nt
erveneinthef or
eignexchangemar kettoinfl
uence
thev al
ueoft hei
rcur r
encies,theset tl
ementsbal ancer et
ainssomesi gnif
icanceandnews
aboutchangesint hereservesoft heaut hori
ti
esisofinteresttoforeignexchangedeal er
sasa
guidetotheamountofof fici
al i
nterventioni
nt heforei
gnexchangemar ket.

CHAPTERSEVEN:FOREI
GNEXCHANGEMARKET

Ethiopi
a’sexchangeratepoli
cieshavebeenaboneofcont ent
ionforconcernedeconomic
analystsandcomment at
orsali
ke.Thesur pri
sedeval
uati
onofthebirronAugust2010from a
value of13.63 tot he US dollarto 16.35 was appar
ent
ly undert
aken t
o boostexpor t
performanceandbringaboutst
r uct
uralchangeint
heeconomy.Explai
nthemeaningofforei
gn
exchange.

7.
1.TheConceptofRat
eOfExchange

Thef or
eignexchangemar keti
sthemar ketinwhi chindi
vi
duals,f
irmsandbanksbuyandsell
for
eigncurrenci
esorforei
gnexchange.Thet ransacti
onint heexchangemarketi
scarr
iedout
whatar etermedexchanger at
es.Thef orei
gnexchanger ateorexchangerat
eistherateat
whichonecur r
encyisexchangedforanother
.Ex changeratecanbequotedintwoways:

i
. Oneunitoffor
eignmoneytoacertainnumberofuni
tsoft
hedomest
iccur
rency(
dir
ect
quot
e).Example$1=17Bir
r
i
i
. Acertai
nnumberofuni t
soff or
eigncurrencyt
ooneunitofdomest
iccurr
ency
.(the
i
ndir
ectquote)
.Exampl
e1Bi r
r=$0. 059.

Notethatt
her ev
ersi
bil
ityi
nt hemodeofquotingexchangeratedoesnotal
terthebasicval
ue
ofonecurrencyintermsofanot her.Whenweexpr esst
hepr i
ceofonecurrencyi
nt ermsof
anot
heritwil
lbeasf ol
lows(Bir
rintermsofDoll
arandDoll
arinter
msBirr
).

Suppl
y,demandandmar
ketf
orf
orei
gnexchange

Thev al
ueofanati
on’smoney,l
i
kemostgoodsandservices,canbeanalyzedbylooki
ngatit
s
supplyanddemand.Forexampleani
ncreaseinthedemandf orthedollarwi
llr
aisei
tspri
ce
(causeanappr
eci
ationi
nitsval
ue)
,whi
leanincreasei
nitssupplywil
llowerit
sprice(
causea
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page47
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

depreci
ati
on)
.Thesear
eonl
ytendenci
es,howev
er,anddependonot
herf
act
orsr
emai
ning
constant
.

A)Demandf
orf
orei
gnexchange

Theexchangerat
eismeasur
edonthevert
icalaxi
sandquant
it
yoft
hefor
eigncur
rency(US$)
i
smeasur edont heX-
axi
s.TheexchangerateRi sameasureofthepr
iceofthef or
eign
cur
rency(US$)i
nter
msofdomest
iccurr
ency(Ethi
opi
aBi
rr)
.

Exchange
rat
e

B2

B3
Demandf orf
orei
gn
exchangefor
eign
(
Dol
l
ar)

Dol
l
ar
1000 2000 3000

Fi
gur
e7.
1showst
hedemandf
orUS$i
nEt
hiopi
a

Ani ncreaseinRi mpliesadecl inei nthev al

ueofBirrandani ncreasei nthevalueofUS$.In
otherwor ds,amov ementupont hev ert
icalaxi
srepresentsani ncreaseint hepri
ceofforei
gn
currency( whichi
sequi val
enttoaf alli
nt hepri
ceofBirr)
.ForEt hiopians,Americangoodsare
l
essexpensi vewhent heDollari scheaperandt heBi r
risstronger .Hence,atthedepreci
ated
valuesf orthedoll
ar,Ethiopi
answi llswit
chf r
om homemadeort hird-part
ysuppliesofgoods
andser v i
cetoAmer icansupplier s.Beforetheycanpur chasegoodsmadei nUSA,howev er,
theymustf ir
stexchangeBi r
rf orUS$.Consequent l
y,theincreaseddemandf orUSgoodsi s
simultaneouslyanincreaseinthequant i
tyofUS$demanded.

B)Suppl
ycur
vef
orf
orei
gnexchange

Thesuppl ycurveoff orei

gncur rencysl opesupbecausef oreignfir
msandconsumer sare
will
ingt o buyagr eaterquant it
yofdomest i
cgoodsast hedomest i
ccur r
encybecomes
cheaper .ThesupplyofUS$wi llincreaseifUSand/ orforeignci t
izensarewill
ingt obuya
greaterquant i
tyofEthiopi
a’sgoodsast heEthiopi
ancurrencybecomescheaper( i
.e.asthe
foreignersreceiv
emor ebirrperUSD) .Beforetheforei
gnci tizenscanbuyEt hiopiagoods,
howev er
,theymustfi
rstconv ertDol l
arintoBir
r,sotheincreasei nquanti
tyofEthiopiangood

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page48
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

demandedissimul
taneousl
yani
ncr
easei
nthequant
it
yoff
orei
gncur
rencysuppl
i
edt
othe
Ethi
opi
anEconomy.

Supplyof
ar
l
Dol

Doll
ar
at
Exchanger Bi
e( r
r/

20,
000 50, 90,
000 Dol
l
ar
0000

Fi
gur
e7.
2Suppl
yoff
orei
gnexchange

C)Themar
ketf
orf
orei
gnexchange

Figure 7.
3 shows (combi
nes)the suppl
yand demand curves offor
eign cur
rency.The
i
nt er
secti
onoft hecur
vesintheEt
hio-
USforei
gnexchangemarketdet
erminestheexchange
rateR1atwhi chthequanti
tyofdemandandsuppl yoffor
eigncurr
encyt otheEt hi
opi
an
Economyar eequal.

Forei
gnexchange
rat
e
Supplyof
Doll
ar

R3

R2

R3
Demandf
or
Dol
lar

Q0 Quant
it
yofDol
l
ar

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page49
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Fi
gur
e7.
3Equi
l
ibr
ium i
nfor
eignexchangemar
ket

Changei
ndemandandsuppl
yoff
orei
gnexchange

Therear
ethr
eemaj
orr
easonswhypeopl
ehol
dfor
eigncur
rencyr
athert
hant
hei
rown.These
are:

 Forreasonsrel
atedtotradeanddirecti
nvest
ment(
li
kebusi
nesscy
cle,i
nfl
ati
onand
expectat
ionoff
utur
eeconomicgrowth)
 totakeadvant
ageofint
erestr
atechanges
 tospeculat
e

Changesinoneormor eoftheset hr
eemot i
vesforholdi
ngf or
eigncurrenci
escanleadt
oa
shi
ftinthedemandandsupplycurvesoffor
eigncurr
encyindi
cati
ngi nchangeindemandand
changeinsupplyofforei
gncurrency.Thefoll
owingtabl
ei sani l
lust
rati
veexampleonthe
deter
minantsofdemandandsupplyofUSDinEthiopi
a.

Tabl
e7.
2Maj
ordet
ermi
nat
esoft
hesuppl
yanddemandf
orf
orei
gncur
rencyi
nEt
hiopi
a.

Fact
ors Incr
ease in demand of Increase in suppl
y of
Ethi
opia f
or for
eign f
oreignexchange
exchange

1)Tr
ade and dir
ect Ethi
opian economic Forei
gn economi
c
i
nvest
mentfactor expansion(mor
eEthiopi
ans expansion ( mor e
export
) Ethi
opiansexport
)
b) The business
cy
cle

c)I
nfl
ati
on Ethi
opi
an i
nflat
ion (f
oreign Forei
gn i
nfl
ati
on
goodsarer
elati
vel
ycheaper) ( Et hi
opian goods
rel
ati
vel
ycheaper
)

d)Expect
ation of I
ncreased pot
ent
ial for I
ncr eased pot enti
al for
fut
uregrowth for
eign gr owth (att
racts Ethiopians growth
outward Et hi
opi
an direct (attr
acts f or
eign di r
ect
i
nvestment) i
nv estmentinEt hi
opia)

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page50
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

2)I
nter
estr
atechanges An i ncr
ease i n forei
gn Ani ncr
easei nEthi
opi
an
i
nterest r at
e/ decl
ine in i
nterestrate/decli
ne i
n
Et
hiopianinter
estr
ate for
eignint
erestr
ate

3)Specul
ati
on Expect
ation of a f uture Expectat
ion ofa fut
ure
decl
inein valueofBir
r/a ri
seint hev al
ueofBirr
/
fut
urerise v
alue off
oreign af ut
uredecli
neval
ueof
curr
ency for
eigncurr
ency

7.
2. Nomi
nalandRealExchangeRat
es

From t
hepointofv i
ewoft our
istsandbusinesspeopl
ewhousef orei
gnexchange,thekeyitem
ofint
erestist hepurchasi ngpowert hattheygetwhent heyconv er
tthei
rdollars,nott he
numberofuni t
sofaf oreigncur r
ency.AnAmer i
canimport
ertr
yingtodeci
debetweenEt hiopia
andKenyant exti
lesdoesnotcar eifheorsheget s8.7bi
rrperdoll
aror73.2KESperdol lar
.
Thebiggestconcernist hev olumeoft ext
il
esthatcanbepurchasedinEthiopi
awi th8.7Bi r
r
andinKenyawi th73.
2KES.

RealExchangeRat
eist
hemar
ketexchanger
ate(
nomi
nal
exchanger
ate)adj
ust
edf
ori
nfl
ati
on.

Rr=Rn(
PF/
PH)-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--(
1)

Wher
eRr=r
eal
exchanger
ate

Rn=mar
ket(
nomi
nal
)exchanger
ate

PH=homecount
rypr
icel
evel

PF=f
orei
gncount
ry’
spr
icel
evel

Abaseyeari
sar
bitr
arychosenasastandardforcompari
son,andPLandPFar
ebot
hequalt
o
100att
hebaseyear
.Thus,thebasey
earrealexchanger
ateis:

Rr=Rn(
100/
100)=Rn-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
-(2)

Overt
ime,i
finf
lat
ioni
shigherathomet
hani
nthef
orei
gncount
ry,
thenPHr
isesmor
ethanPF,
andRrfal
l
sifRnisconst
ant.Thi
smeans:

 Domesti
ccurrencyappreci
atesi
nrealt
erms
 For
eigncur
rencydepreciat
esinr
ealter
ms

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page51
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Exampl e:Thebaseyearnomi
nalormar ketexchanger at
ei ntheEthi
o-USf
orei
gnexchange
mar ketis8.7bi
rrperUSD.Afterayeart her
ehasbeen10% i nfl
ati
oninEthi
opi
awhilethe
i
nflati
oninUSAiszeroper
cent
.Calcul
atetherealexchangerate.

Rr=Rn(
PF/
PH)

=8.
7(100/
110)

=7.
91Bi
rr
/USD

Tour i
sts,i
nvestors,andbusi nesspeopl ecanst i
llt
radebi r
randUSD att henomi nalrate
(8.7B/USD)pluswhat evercommi ssionstheymustpayt ot hesell
ers).Aft
erthepriceincrease
(i
nf l
ati
on)inEthiopia, t
herealpurchasingpoweroftheBi r
rhasr i
seni nUSAcompar edtowhat
i
tbuy sathome.Ther ealexchanger ateof7.91Birr
/USDt el
lsust hatUSgoodsar enow 10
percentcheapert han Ethiopian goodst hathaver i
sen in pri
ce.Asl ong asthenomi nal
exchanger ater emai nsunchanged,USgoodsr emainlessexpensi vetobot hEthiopianand
Amer icanpurchaser s.Inr
ealtermst heUSDhasdepr eciatedandt heBirrhasappreciat
ed.The
realexchanger ateisusef ulf
orexami ningchangesovertimei nther el
ati
vepurchasingpower
off or
eigncurrenci
es.

7.
3.Det
ermi
nat
esofExchangeRat
eint
heLong-
Run

Few tasksineconomi csaremor ediff

icul
tandriski
erthant r
yingtopredi
ctexchanger at
e.
Currencymarketsareasv ol
ati
leasstockmar ket
s,andnooney ethasbeenabletodev i
sea
system toconsist
entl
yforecastexchangerat
es.Nev er
thel
ess,ther
eissubstanti
alevidence
thatovertheverylongrun(peri
odsofadecadeormor e),exchangerat
esaredeterminedby
twomai nfact
ors.

 Pur
chasingPowerPar
it
y(PPP)
 Di
ff
erencesinpr
oduct
ivegr
owthbet
weencount
ri
es

Pur
chasi
ngpowerpar
it
y

Purchasi
ngpowerpar i
tyalsotermedasl awofonepr ice,statesthatacurrencyshoul
dbuyt he
samequant i
tyofgoodswhenconv ert
edt oanothercur rencyasi tcanbuyathome.I faunitof
homecur r
encycanbuyacer tai
nquantit
yofmar ketbasket sofgoodsi nthehomemar ket,
the
sameuni tofhomecur rencyconv er
tedt oitsequi valentforeigncur r
encymustbuyequal
quanti
tyofmar ketsbasket sofgoodsf r
om t hef or
eignmar ket.Inotherwords,theexchange
rat
eshouldbeatal evelthatkeepsther ealpurchasingpowerofmoneyconst antwhenitis
convert
edtoanot hercurrency.

I
fthel
aw ofonepr
icedoesnothol
d,abi
rri
nEt
hiopi
abuy
sadi
ff
erent(
lar
gerorsmal
l
er)
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page52
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

bundleofgoodst hanitbuysfr
om USAwhent heBirri
sconv ert
edint
oDollar
.Ifbi
rrbuy
smor e
i
nEt hi
opiathanitsdoll
arequival
entbuysinUSA,thenbusinesspeoplecoul
dmakepr ofi
tbuy
shi
ppinggoodsf rom Ethi
opiawheretheyarer
elat
ivel
ycheapandsellthem i
nUSAwher ethey
arerelati
vel
yexpensive.Ifabi r
rwor t
hofdollarbuysmor einUSA,goodswi l
lfl
ow inthe
oppositedir
ect
ion,fr
om USAt oEthi
opia.

Thel aw ofonepr i
cecanbet houghtofasal ong-runt endencyf orther ealexchanger ateto
remai nconstant.Sincet herealexchanger ateequalst henomi nalrat
et i
mest herelat
ivepr i
ce
l
ev els,thelaw ofonepr iceessenti
allystatesthati fforeignpr i
cesr i
semor ethandomest i
c
prices( ∆PF>∆PH) ,t henthenomi nalratedecr easebyt hesameper centage( Rnf all
sandi t
takesf ewerBirrtobuyauni tofforei
gncur rency).Thesef orcescant akehi ghl
yv ari
ableand
somet i
mesv erylongper iodsoftimet omat eri
ali
ze,howev er, sothelawofonepr i
cedoesnot
per mitanyonetof orecasttomor r
ow’sornexty ear’sBirr
-dol larexchanger ate.Inaddi t
ion,even
overt helong-r
un, t
herecanbesubst anti
aldev i
ati
onsi nanat ion’scurr
encyf rom thelawofone
price.

Di
ff
erencesi
npr
oduct
ivi
tygr
owt
hrat
es

Fasterpr oductivi
tygrowt hi sequi valenttoar elativ
edecl i
nei npricesandl eadst oar eal
appreciati
oni ncur rencyv al
uesov ert helongr un.Letust akeahi stori
caldataonUS–
JapaneseandUS- Germanexchanger ateov ertheper iod1980–1994asshowni nt abl e5.1.
Thehi gherpr oducti
v i
tygr owt hinJapanandGer manyr el
ativetotheUSpr oductivi
tygr owth
overtheper iod1980t o1994r esul
tedi nani ncreasei nt hemar ketexchanger atei nt heUS-
JapanandUS- Germanyf oreignexchangemar ket.Forexampl eoft he4. 9% i
ncreasei nUSD-
Yenmar ketexchanger ate, 2.
1%oft hei ncreasewasduet ohigherproduct i
vi
tygrowt hinJapan
rel
ativ
et oUSA, 0.
9%oft hei ncreasewasduet ohi gherinflat
ioninUSAr elati
vetot hei nfl
ati
on
i
nJapanov ert heindicatedper iod.Ther emai ning1. 9% increasewasduet ounex plainedor
stochasticfactorsthatmayhav eeffectonexchanger ate.

Tabl
e7.
3Det
ermi
nant
sofl
ong-
runchar
gesi
nexchanger
ate,
US-
JapanandUS-
Ger
many
,1980-
1994

US–Japan
US–Ger
many

(∆PH-∆PF)inper
centwherePHis 0.
9% 1.
9%
pri
ceinUSandPFispri
celevel
in
for
eign

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page53
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Dif
fer
encesi
nproduct
ivi
tygr
owth 2.
1% 1.
1%
(f
orei
gnminusUS)inper
cent)

∆Rn,
inper
cent +4.
9% +3.
2%

Unexpl
ainedpor
ti
on 4.
9-3.
0=1.
9% 3.
2-3.
0=0.
2%

Sour
ce:
Kennet
hKasa“Under
standingTr
endsi
nfor
eignexchanger
ates’
”FRBSFweekl
ylet
ter
,
FRBofSanFr
anci
sco,h.9,1995

3.
2.3.
7.3.ExchangeRat
eSy
stems

Exchanger at
esystemsar et
herul
esthatnationsattachtot hemov ementoft
hei
rexchange
rates.Thereareanumberofdif
fer
entcategori
esofset sorrulesthatnat
ionsmayadopt
,but
theyallaremodif
icat
ionsoft
wofundamentalcategor
ies.Theseare:

 Fi
xedexchangerat
esyst
em
 Fl
oati
ngexchangerat
esyst
em

Histor
ical
ly,
fixedexchangerat
esy st
emshav
eusuallybeenagoldstandardoramodi f
iedgold
standardandhav ebeenfarmorecommont hanaf l
oati
ngexchanger at
esy st
em.Bothf i
xed
and float
ing exchangeratesystemshaveadv ant
agesand disadvantages.Thewei ghtof
economi copinionhasprobabl
ytendedt
ofavorfl
oati
ngexchangerates,al
thought
hisisbyno
meansunani mous.

Not
e:Deval
uat
ionandreval
uat
ionar
eequival
entt
odepreci
ati
onandappr eci
ati
on,exceptt
hat
t
hefi
rstgr
oupref
erst
ochangesinacur
rency'
sval
ueunderafixedexchangerat
esystem.

Devaluati
onisadecl
i
nei ntheval
ueofacur r
encyunderaf
ixedexchanger
atesyst
em,whi
l
e
depreciat
ioni
sadecl
ineunderafl
exi
blesyst
em.

Reval
uati
onisanincr
easeintheval
ueofcurr
encyunderafixedexchanger at
esystem whi
l
e
anappreci
ati
oni
sanincreasei
ntheval
ueofcurr
encyunderaflexi
bleexchangerat
e.

7.3ExchangeControl
I
tshouldbenotedatthever
youtsetthat
,exchangecontr
ols,l
ikecurr
encydeval
uati
ons,
forma
partofexpendit
ure-
swit
chi
ng poli
cypackage.Because,t heytoo,likedeval
uati
on,aim at
di
rect
ingdomesticspendi
ngawayf rom for
eignsuppli
esandi nvest
ment.Exchangecontr
ols
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
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nessManagement
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nter
nat
ionalTr
adeandFi
nance

tr
yt o di
ver
tdomest i
c spendi
ng i
nto consumpti
on ofdomesti
cal
lypr
oduced goods and
serv
icesontheonehandandintodomesti
cinvest
mentontheot
her.

Obj
ect
ivesofexchangecont
rol

Theobjectofcont
rol
l
ingexchangeist
of i
xitatalev
eldi
ff
erentf
rom whatitwoul
dbei fthe
economicforceswer
epermitt
edfreei
nterpl
ay.Theobj
ect
ivesofexchangecont
rolcouldbeto:

 correctaser iousimbal anceintheeconomyoft hecountryr el

ati
vel
ytotheoutside
wor l
d; or
 permi tnati
onal economi esandpol icyarchit
ectsabr oadfreedom ofacti
onbot hin
emer gencyandnor maleconomi csituati
onsandwar rant
yt hedecisi
ontopursue
domest i
cpoliciesofeconomi cgrowthanddev elopment;or
 correctaper sistentl
yadv er
sebal anceofpay ment s;or
 preventaf li
ghtofcapi talfr
om thecount ry;or
 conser veforeignexchanger eservesf orlar
gepay mentsabroad,i.
efaci
l
itat
eser vi
cingof
foreigndebt ;or
 mai ntainstableex changerate,ortoensur egrowt hwithstabil
it
y,andsoon

I
nallt
hesecir
cumstances,afr
eeexchangewoul
dbeei
therembarrassi
ngorpr
ejudi
cial
tot
he
obj
ecti
nview,andexchangecont
rolbecomesani
mper
ativenecessi
ty.

Met
hodsofexchangecont
rol

Exchangecont rol
smaybebr oadlyclassif
iedintotwogroups-di rectandindir
ectexchange
controls.Amongt hedir
ectmet hodsment ionmaybemadeofi ntervent
ionandr egul
ati
onin
mattersconcer ni
ngexchanger ates,forei
gnexchanger estr
ict
ions,mul ti
pleexchanger at
e
poli
cieset c.I
ndir
ectmet hodsofexchangecont roli
ncl
udeimpor ttari
ff
s,exportsubsi
dies,
bi
lateral&multi
lat
eralcl
eari
ngarrangement s,et
c.

A.Di
rectmet
hodsofexchangecont
rol

1.For
eignexchanger
ater
egul
ati
ont
hroughi
nter
vent
ion

Thegov ernmentmayi nterveneintheforei

gnexchangemar ketwithav i
ewt or ai
seorr educe
theexternalvalueofitshomecur r
ency.Thisint
erventiontakest heform oflarge-scalebuying
orsell
ingofhomecur r
encybyt hegov er
nmentint hef orei
gnexchangemar ket .Thei deaisto
supportor" peg"t heex ternalval
ueoft hecur r
encyt oachosenr at
eofexchange.I nt he
absenceofsuchpeggi ngorgov er
nmentsuppor tthroughi nter
venti
on,therei sar iskthatthe
free marketr ate offoreign exchange would di
v erge fr
om t he pegged r ate.Putsi mply,
governmentwi llsel
lforei
gnexchangewhent hepriceoff orei
gnexchangei sr i
singexcessi vel
y
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page55
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

ont hef or
ei gnexchangemar ket;andgov er
nmentwillbuyf orei
gnexchangewhent hef orei
gn
exchanger ateisgoingdownexcessi v el
ycausingappreciationofdomesticcur
rencyint erms
off orei
gncur r
ency.Sincebot hdepr eci
at i
onandappr eciationofcurr
encyarer egardedas
undesi r
able,thereisneedf orgov ernmenti nter
vent
ioninkeepi ngexchangeratesr elati
vel
y
stable.Exchanger atestabil
it
yi snecessar ytofacil
it
ateand pr omotehealthygr owth of
i
nt er
national t
radeandcapitalmov ement s.

Exchanger atest
abi li
tyi st hreatenedof fandonbyBOPdef ici
tandsur pluspr essur esont he
onehandandbyt hespecul ativebuy ingandsel li
ngoff oreignexchangeofadest abili
zingty pe,
ont heot her.Hence,t heneedf orgov ernmenti nterventiont o"smoot henout "suchupsand
downsi ntheexchanger atemov ementf rom ti
met ot ime.Itisrelat
ivelyeasi erforacount r
yt o
sellitshomecur rencyandbuyexcessamountoff oreignexchanget opr ev entdepr eciati
onof
foreignexchange( orappr eci ati
onofi tsowncur rency ),becauseev erycount ryhasunl imited
suppl i
esofi t
sowncur r ency .Allthatt hegov er
nment shav etodoi stogot ot heprintingpr ess
andgetmor ecur
rencynot es.Ont heot herhand, thef orei
gnexchanger eser vesatt hedi sposal
ofacount ryarerat herst rictl
ylimi t
ed.Ther efore,ift hefor ei
gnexchanger ateisappr eci
ating
duet oscar cit
yoff oreignexchange( i.
e.thedomest i
ccur rencyisdepr eci
at ingagainstf oreign
currency),itwoul d notbe easyf orgov ernment st o sel lunli
mited quant i
ti
es off oreign
exchanget opr ev
entar isei nt heforeignexchanger ate.Gov ernmentintervent i
on,howev er,has
tobeofbot hthety pespeggi nguporpeggi ngdown.Thecompl exi
t yort hecasewi thwhi ch
theycanbeunder takenar e, howev er,quitediff
erent

2.Exchanger
est
ri
cti
ons

Thisisanother
,andperhapsmor esevere,f
orm ofexchangecont
rols.I
nthi
scase,al
lfor
eign
exchangeearni
ngsandr eceiptsmustbesur r
enderedtothegovernmentandexchangedfor
homecur r
ency;andfor
eignexchangecanbepur chasedonlyfr
om t
hegov er
nmentaut
hori
ti
es.
Non-compli
ancewithcurrencytransact
ionsandregulat
ionslai
ddownbyt hegov
ernmentsare
acrimeevenpunishabl
ewi thdeathasinGer manyin1931.

Gov ernmentwi l
lacquir
eall f
oreignexchangecomi ngi ntothecount ry,anditwi l
lall
ocateorsell
thatf oreignexchangetobuy er
sont hebasisofpr edeter mi
nednat i
onalpri
oriti
es.Forexampl e,
foreignexchangemaynotbemadeav ai
labl
eforal lkindsoff orei
gntour,tr
av elorstudyorfor
non- essent i
alimportofgoodsandser vi
ces,andsof orth.Acount r
ymaypr acticeasy st
em of
whati scalledas" bl
ockedaccount s"i.
e.notall
owi ngt hecr editor
soft hesebl ockedaccounts
touset hei
rcur r
encyholdingsint heiraccounts.For eigninv estmentbynat ionalsmaynotbe
permi ttedduet oshort
ageoff oreignexchange.Onecanv isuali
zeanynumberofmeasur es
whi chgov ernmentsmayt aketocopser vescarcef or ei
gnexchange,andt heyal lconst
it
ute
foreignexchanger estr
ict
ionsasaf orm ofexchangecont r
ols.

3.Mul
ti
pleexchanger
atepol
ici
es
Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page56
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ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Multi
pleexchanger atesweref i
rstempl oy edbyGer manyandl at
ertheywer efol
lowedbyother
countri
eslikeAr genti
na,Brazil,andChi le,Ecuador ,Peruandmanyot hers.Inthecaseofthis
poli
cy,dif
ferentexchanger atesar efixedf orimportsandexportsofdif
ferentgoods.Evenfor
di
fferentcategoriesofi mports,diff
erentexchanger at
esareappli
ed.Argentinamaintai
neda
hi
ghercompl exsy st
em ofmul tipl
eexchanger ates,
becauseshewasnotamemberoft heIMF.
Thesy st
em wasadmi ni
ster
edqui teefficientlyforalongti
me.

The mechani sm ofmul tiple exchange r ates i

sv ery simple.Suppose f orexampl e,the
gov er
nmentconsi deredi mpor tsofsomer awmat eri
alsandcapi t
algoodsasessent i
alt othe
economi cdev elopmentoft hecount ry;thentheforei
gnexchanger ateusedint hecaseofsuch
i
mpor t
swoul dbel ower ,say1USD=5Bi r
rratherthant hestandardexchanger ateof ,say1
USD=8. 70Bi rr.IntermsofBi rr(homecur r
ency)theimpor t
erpaysalowerpr i
ceforobt aini
nga
givenamountofUSD( f oreignexchange) .Thiswouldmakei mportsofsuchgoodscheaper ,
becauset heBi rrpri
ceofUSDf ixedf ortheirimportsislower.Ontheotherhand, i
mpor t
sofnon
-essenti
alluxur ygoodsmaybesubj ectedt oahigherforei
gnexchanger at
e,say1USD=15Bi rr
.
Thiswoul draisev alueofUSDi nt ermsofBi r
randmakei mportoftheluxurygoodsr at
herv ery
expensive.Thesamedi scriminat oryexchanger atepoli
cycouldbeappl i
edt oexportgoodsas
well t
oencour ageexpor tsofcer taintypesofgoodsandser vi
cesmorethanot hers.

Thepol i
cyofmul ti
pleexchanger atesisalsocalledselecti
v edeval
uat i
onpolicyasopposedt o
generaldeval
uationpolicy .Inthecaseofgener aldevaluati
onpol i
cy,importsofal lgoodsand
serv
icesaremadeexpensi ve,r
egar dl
essofwhet hert
heyar eessentialornonessent i
altypesof
i
mpor ts.Si
milarl
y,gener allydevaluati
onwoul dmakeal ltheexportsat t
racti
ver egardlessof
whatt heexportcommodi tyis.Mul ti
pleexchanger at
epol i
cyunder takesselecti
vedev aluati
on
i
.e.i
twoul dmakeessent ialimpor t
scheaperandnonessent i
alimportsexpensive,andi twould
makesomeexpor t
sattr
act i
veandot herexportsunattr
act i
ve.

Mul
ti
pleexchanger
atepoli
cywil
lhavediff
erentexchangerat
esnotonl
yfordi
ff
erentgoods
(
impor
tedandexpor
ted)butal
sofordi
ff
erentcount
rieswit
hwhicht
hehomecountr
yistr
ading.

Theadv antageofmul t
ipleexchanger atepolicyt ot hepr act ici
ngcount r
yli
esint hefactthatit
eli
mi nates t he need f orempl oying quant itati
ver est
rictions on i mport
s( orexpor ts)and
l
icensingofi mpor t
s( orexpor t
s).Tot hatext ent ,thissy st em canel i
minateineffi
ciencyand
corruptiont hatusuallygowi t
himpor tlicensingandquant i
tat iv
er estri
cti
onsoni mports.Thi
si s
perhapst hegr eatmer i
tofmul t
ipl
eexchanger atesv is-a-visphysi calcontrol
soni mports.
Howev er,ther earesev eralshort
comi ngsassoci at edwitht hemul ti
pleexchanger at
esy st
ems.
Forexampl e, thesystem i nt
roducescompl exityandl otofconf usionwithregardtothenumber
ofexchanger atesappl i
cabletonumberofcommodi t
iesi nr el
at i
ont onumberofcount r
ies.
Somet imes, theycanhar m healthyeconomi cdev elopmentofacount ry
.

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page57
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ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page58
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ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

B.I
ndi
rectmet
hodsoff
orei
gnexchangecont
rol

Among the indi

rectmet hods ofexchange cont
rolto menti
on ar
e:exchange clear
ing
agr
eements,i
mpor tr
estr
icti
ons,
tar
if
fsandimportquot
asarethechi
efi
nst
rumentsofindir
ect
methodsofexchangecontrol
.

1.Exchangecl
ear
ingagr
eement
s

Exchangecl eari
ngagreement scanbebi l
ateralormultil
ateral,pr
ivateorof f
ici
al.Thewor ldhas
witnessedallsuchdi f
ferentt y
pesofagr eement sov erthepastsev eralyear
s.Bilater alcleari
ng
arr
angement sleadtoasy stem ofint
ernationaltradeandpay ment sofabar t
ernat ur e.Among
theearli
estformsofbi lateraltr
adewer ebar terdealsunder t
akenbypr iv
atef i
rms.Ifal lexport
s
andi mportsofacount ryar ecarr
iedouti nsuchabi lateralbarterfashion,therewoul dbeno
BOPdef ici
tsorsur pl
usesi nanycount ry.Ther ewouldev enbenoneedt ousemoneyorf orei
gn
exchange in set t
li
ng internati
onaltrade and pay mentobl i
gations.Such bi l
ater alcl eari
ng
arr
angement sareempl oyedbyCommuni stcount ri
esintradingwi thoneanot her.

Onepr oblem wi
thsucharrangementsisthatt
heexporterhastoplayt her ol
eofani mpor t
eras
well,andexporter
smaynotbeaccust omedt oplayi
ngsuchdualr oles.Ger manyev olveda
noveldev i
ceofexchangecleari
ngwhichhadt headvantageofreli
evi
ngt heexporterfrom al
so
performingtheunaccust
omedf unct
ionsofani mport
er.Thisl
edt oasy stem ofbart
ercleari
ng
agreement sbetweengov er
nmentsi .
e.thecent r
albanksoft het wot radi
ngnat ions.Such
arr
angement sofBOPset t
lementarestri
ctl
yli
mitedtocommodi tytr
adebet weencount ri
es.

2.Tar
if
fsandquot
as

Tarif
fsandquotasoni mportsareindi
rectexchangecont
rolmethodsinsofarastheybecome
necessaryassoonasdi r
ectexchangecontrolmethodsar
eadoptedinacount ry
.Totheextent
thattarif
fsand quotassucceed in cutti
ng down importexpendi
tures,wit
houtmat er
ial
ly
reducingexpor
trecei
pts,t
heywillcont
ribut
et owar
dsanimprovementint heBOPbalanceofa
country.

Impor tduti
eslev i
edf orr evenueconsideratonort
i ost i
mulatedomest i
cindust r
ial
i
z at
ion,can
beconsi deredasi ndirectexchangecont r
olmet hods.Simil
arly,exportsubsidi
eswi thav iewt o
expandexpor tsneednotnecessar i
lyfalli
ntothecat egoryofexchangecont rols.Onlywhent he
objectiv
eofi mpor tdut i
esorquot asorexpor tduti
esorsubsi diesisexpl i
cit
lytosuppor tthe
for
ei gnexchanger ateori mprovetheBOPsi tuati
on,cant heybet r
ulyconsideredasi ndi r
ect
met hodsofexchangescont rol
.Inr
ealit
y,howev er,i
tisverydiffi
culttoidenti
fywhet heragi ven
i
mpor t
antt ar
if
forexpor tsubsidyisi ntroduced forconsi derat
ionsofr evenueorf oreign
exchangeear nings( savingtoimproveBOPsi tuat
ion).Thesameki ndofdiffi
cultyextendsal so
tonon- t
ari
ffbarri
erswhi chacountrymayi mpose.

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page59
Agr
ibusi
nessManagement
: I
nter
nat
ionalTr
adeandFi
nance

Thei
robject
ivesar
esonumeroust
hati
salmosti
mpossibl
etoi
dent
if
ywi
thcer
tai
ntyt
hatt
hey
aremeantsolel
ytoimpr
ovet
heBOPsit
uat
ionofacount
ry.

1.Rober
tJ.Car
baugh.
2004.I
nter
nat
ional
Economi 9thedi
cs, ti
on.
2.HGMannur.
1995.I
nter
nat
ional
Economi 2ndr
cs, evi
sededi
ti
on.
3.Kr
ugnan,PaulandMaur
ueObst
fel
d.1997.
Int
ernat
ionalEconomi
cs:Theor
yandPol
i
cy,
Addi
son-
Wesl
eypr
ess
4.B.Soder
sten.
1980.I
nter
nat
ional
economi
cs2ndEdi
ti
on,
Macmi
l
lanpr
ess,
London
5.Haj
ela,
T.N.
1998.Money
,Banki
ng,
andI
nter
nat
ional
Trade.7thEdi
ti
on,
Konar
k,Del
hi.
6.Jhi
ngan,
M.L.2007.I
nter
nat
ional
Economi 5thEdi
cs, ti
on,
Vri
nda,
Indi
a
7.Manur
,H.
G.1983.I
nter
nat
ional cs.2ndEdi
Economi ti
on,
Vikas,
Del
hi.

8.Sal
vat
oreDomi
nidi
k.2001.
Int
ernat
ionalEconomi
cs,7t
hEdi
ti
on,JohnWi
l
ly&Sons,New
Yor
k.

Ji
mma,
Har
amay
a,Hawassa,
Ambo,
Adama,
Bahi
rdar
,Wol
ait
aSodoandSamar
aUni
ver
sit
ies
Page60