International Trade

B.com-II Sem-iv Unit-III Notes

Prepared by Dr. Jamma A.P.
Trade is referred to as an economic concept that is involved with
buying and selling of goods. Trade is conducted between two or more
parties which can be an individual or a business entity.
Trade can be of two types :
1) Internal Trade
2) External Trade
1Internal trade
is the trade that is conducted between parties within the political and
geographical boundaries of a nation,
International trade
is the trade that is conducted between two parties that are outside the
nation’s borders or between two countries.
Let us look at some of the points of difference between internal and
external trade.

Internal Trade International Trade

Definition

Internal trade is trade that involves buying and External trade is referred to as a trade that
selling taking place between two parties which involves buying and selling of goods between
are located within the political and geographical two parties located in different countries or
boundaries of a country between two different countries

Countries Involved

Internal trade takes place between the country External trade involves the transactions between
borders, therefore only one country is involved two or more countries.
Currency involved

Domestic currency will be used as the medium of Payments for external trade transactions are
payment for all the transactions received in a currency that is mutually agreed by
the two parties involved in the trade

Risk Involved

Internal trade has less risk as compared to External trade will be having more risk which
external trade can be due to currency fluctuations, economic
state of countries, etc

Impact on Foreign Reserve

No impact on foreign reserve as transactions take Foreign trade helps in adding to the foreign
place within the country reserve of the country

Restrictions

Internal trade has less restrictions External trade is subjected to many restrictions as
it is between two countries, which involve
different laws

Advantages of International Trade:

Optimum usage of resources:

When countries try to produce the product that is the best suitable
given the conditions that prevail in the country, they use the resources to
the best capacity possible. Due to this, there is no underutilization of
resources.

Wider variety of products available to consumers:

Due to trade, the products from other countries are imported, and the
consumers have a wide choice of items to choose from. They can get the
best that they want, and it is an advantageous situation for them.
Economies of scale:

Due to countries producing those goods as well as services they are

good at, there is scope for establishing many units of the same, and they
can all cooperate. This helps in channeling the collective effort of the
people.

Exchange of technical:

When the people of a country try to imbibe the practices that are
followed in another country, there is a great transfer of knowledge. Also,
a very important component, technology, is transferred among the
peoples.

Large-scale production:

Due to economies of scale, large-scale production of the goods is

facilitated. The surplus can be exported to other countries, thus increasing
the foreign exchange reserves.

Ability to face contingencies:

In case of any disasters or other unforeseen incidents, the

international community can be of help by exporting their goods to the
country that has been affected.

Establishment of new industries:

Through interaction among countries, there is scope for the

exchange of knowledge about the industries indigenous to each other, and
these industries can be introduced in the others.

Extension of means of transport:

 So as to facilitate the transportation of goods, transportation
infrastructure is improved among countries, and this also benefits peoples
in both the countries.

International cooperation:

Since all the countries are so interdependent, every nation doesn’t

always work in the national interest. They acknowledge the impact that
their policies might potentially have on their partners and this, in turn,
leads to international cooperation.

Speedy industrialization:

Introduction of Multi-National Companies (MNCs) into the economy

helps the country develop since it helps in industrialization while also
creating employment opportunities for the local people.

Disadvantages of International Trade:

Hurdles to indigenous industries:

Domestic unemployment is caused in the case of handicrafts and

other such indigenous industries. People are attracted to foreign brands
that are cheaper.

Political dependence:

Due to the interdependence with respect to some very essential

goods, countries try to maintain friendly relations with their major trading
partners. Since trade helps in increasing the foreign exchange reserves,
there is no reason as to why two trading partners would want political
rivalry. This, over time, becomes dependent.

Disruption in the usual consumption habits:

 Due to trade, many new products like luxury items, drugs, and
other potentially harmful commodities are introduced into the market.
People get easily attracted to them, and this changes the consumers’
behaviors.

Loss of self-sufficiency:

This is self-explanatory by the way that if two countries are

economically dependent on each other, they produce lesser of that
product that they are importing. This leads to more economic
dependence.

Impediment to internal peace:

Due to nationals belonging to the countries that a country is trading

with coming into the country and settling there for work purposes, there
could be a change in demographics and hence can trigger conflicts.

Predatory pricing:

International firms can establish themselves easily in other nations.

They initially sell products at very low prices, and the local sellers are
wiped out of the market. Through this, the multinational establish sole
control over the market (monopoly) and eventually introduces
skyrocketing prices.

Over-utilization of natural resources:

Multinationals usually set up their industries close to water bodies

or in rural areas and eventually exploit the natural resources there.

Shortage of goods:

Some countries produce huge amounts of a good and export it to

other countries. Over a period of time, when an unexpected rise in the
need for this good arises, it has a minimum quantity of the good.
Ricardian theory of comparative cost

Introduction

Due to differences in climate, natural resources, geographical

situation and efficiency of labour, a country can produce one commodity
at a lower cost than the other because of these comparative advantages.
When a country enters into trade with some other country, it will export
those commodities in which its comparative production costs are less,
and will import those commodities in which its comparative production
costs are high. The principle of comparative advantage has been the basis
of international trade for over a century till the First World War. This is
the basic of the Ricardian theory.The existence of comparative advantage
in costs of production is the principal cause of emergence of international
trade. It may be assumed that the opportunity cost is subject to constant
cost, increasing cost and decreasing cost explaining with the help of
production possibility curve.

Ricardo’s Model of Comparative Advantages

According to David Ricardo, it is not only the absolute but the

comparative differences in costs that determine trade relations between
two countries. Production costs differ in countries because of
geographical division of labour and specialisation in production. Due to
differences in climate, natural resources, geographical situation and
efficiency of labour, a country can produce one commodity at a lower
cost than the other because of these comparative advantages. In this way,
each country specialises in the production of that commodity in which its
comparative cost of production is the least. Therefore, when a country
enters into trade with some other country, it will export those
commodities in which its comparative production costs are less, and will
import those commodities in which its comparative production costs are
high. According to Ricardo, this is the basis of international trade. It
follows that each country will specialise in the production of those
commodities in which it has the greatest comparative advantage or the
least comparative disadvantage. Thus, a country will export those
commodities in which its comparative advantage is the greatest and
import those commodities in which its comparative disadvantage is the
least.
Assumptions

The Ricardian theory of comparative advantage is based on the

following assumptions:

1. There are only two countries, say England and Portugal.

2. They produce the same two commodities say, wine and cloth.

3. There are similar tastes in both countries.

4. Labour is the only factor of production.

5. The supply of labour is unchanged.

6. All units of labour are homogeneous.

7. Prices of two commodities are determined by labour cost, i.e, the

number of labour units employed to produce each.

8. Commodities are produced under the law of constant costs or returns.

9. Technological knowledge is unchanged.

10. Trade between the two countries takes place on the basis of the barter
system.

11. Factors of production are perfectly mobile within each country, but
are perfectly immobile between countries.

12. There is free trade between the two countries, there being no trade
barriers or restrictions in the movement of commodities.

13. No transport costs are involved in carrying trade between the two
countries.

14. All factors of production are fully employed in both the countries.

15. The international market is perfect so that the exchange ratio for the
two commodities is the same.

Explanation of the Theory

Given these assumptions, Ricardo shows that trade is possible

between two countries even when one country has an absolute advantage
in the production of both commodities, but the country has a
comparative advantage in the production of one commodity than in the
other. This is illustrated in terms of Ricardo’s well-known example of
trade between England and Portugal as shown in table 1.1

Table:1.1 Labour required for producing one unit

country wine cloth

England 120 100
Portugal 80 90

The table 1.1 shows the production of a unit of wine in England

requires 120 men for a year, while a unit of cloth requires 100 men for
the same period. On the other hand, the production of the same quantities
of wine and cloth in Portugal requires 80 and 90 men respectively. Thus,
England uses more labour than Portugal in producing both wine and
cloth. In other words, the Portuguese labour is more efficient than the
English labour in producing both the products. So Portugal possesses an
absolute advantage in both wine and cloth. But Portugal would benefit
more by producing wine and exporting it to England because it possesses
greater comparative advantage in it. This is because the cost of
production of wine (80/120 men) is less than the cost of production of
cloth (90/100 men). On the other hand, it is in England’s interest to
specialise in the production of cloth in which it has the least comparative
disadvantage. This is because the cost of production of cloth in England
in less (100/90 men) as compared with wine (120/80 men). Thus, trade is
beneficial for both the countries.

Meaning of the Terms of Trade

The terms of trade are defined as the ratio between export price of a
commodity and import price of a commodity. If the export price of a
commodity increases more than the import price of a commodity, a
country has a positive terms of trade, as for the same amount of exports,
it can purchase more imports. However, trade today, is not fixed in one
commodity only and multi-commodities play an active part in the process
of trade. Under such circumstances, average exports and average imports
price index are taken into consideration for calculation of terms of trade.
 Trade, in goods and services, is defined as the transactions in goods
and services between residents and non-residents. It is measured in
million US dollar, as percentage of Gross Domestic Product for net trade,
and also in annual growth for exports and imports. Therefore, we
calculate the terms of trade as an index number using the following
formula

TOT = Px/Py*100

where Px is the average Export Price index and Pm is the average

Import Price Index of a country. If a country can buy more imports with a
given quantity of exports, its terms of trade are better-off or improved.. If
import prices rise faster than export prices, the terms of trade are worse-
off or deteriorated. A greater volume of exports has to be sold to finance
a given amount of imported goods and services. Typically, this leads to a
fall in the standard of living because imports of foods and technologies
are more costly. The terms of trade fluctuate in line with changes in
export and import prices. The exchange rate and the rate of inflation can
both influence the direction of any change in terms of trade. A key
variable for many developing countries is the world price received for
exports of primary commodity e.g. the world export price for coffee, raw
sugar cane, iron ore and soybeans.

Types of terms of trade

1. Gross barter terms of trade:

The Gross barter terms of trade (G) is the ratio of the quantity of goods
exported of a country to the quantity of goods imported multiplied by 100
to express the terms of trade in percentages. That is:
Qm
G= × 100
Qx

Where, G stands for Gross barter terms of trade

Qm stands for an index of the volume or quantity of imports and

Qx for an index of the volume or quantity of exports.

To measure it in percentages, it is multiplied by 100.

2.Net barter terms of trade:

The commodity or net barter terms of trade (N) is the ratio of the
price index of the country’s exports ( Px ), to the price index of its
imports ( Pm ), multiplied by 100 to express the terms of trade in
percentages.
px
N= ×100
pm

For example, if we take 1990 as the base year (N-100), and we find that
by the end of 2018, the country’s Px fell by 5% (to 95), while its Pm rose
by 10% (to 110), then this country’s commodity terms of trade declined
to 100 86.36 110  x 95 N This means that between 1990 and 2018, the
country’s export prices fell by 14% in relation to its import prices.

3.Income terms of trade:

A country’s income terms of trade (I) are given by:

px
I= × Qx
pm

Where, Qx is an index of the volume of exports of a country.

Thus, I measures the country’s export-based capacity to import. In

our example, if Qx rose from 100 in 1990 to 120 in 2018, then the
country’s income terms of trade rose to 120 0.8636 120 103.63 110  x 
X 95 I This means that from 1990 to 2018 the country’s capacity to
import (based on its export earnings) increased by 3.63% (even though m
x P P declined). The change in the income terms of trade is very
important for developing countries, since they rely to a large extent on
imported capital goods for their development.
BALANCE OF PAYMENT
Balance of Payments According to Kindle Berger, "The
balance of payments of a country is a systematic record of all economic
transactions between the residents of the reporting country and
residents of foreign countries during a given period of time". It is a
double entry system of record of all economic transactions between the
residents of the country and the rest of the world carried out in a
specific period of time when we say “a country’s balance of payments”
we are referring to the transactions of its citizens and government.
The balance of payments of a country is a systematic record of
all economic transactions between the residents of a country and the rest
of the world.

It presents a classified record of all receipts on account of goods

exported, services rendered and capital received by residents and
payments made by them on account of goods imported and services
received from the capital transferred to non-residents or foreigners. -
Reserve Bank of India

BALANCE OF TRADE

The difference between a country's imports and its exports.

Balance of trade is the largest component of a country's balance of
payments. Debit items include imports, foreign aid, domestic spending
abroad and domestic investments abroad. Credit items include exports,
foreign spending in the domestic economy and foreign investments in the
domestic economy. When exports are greater than imports than the BOT
is favourable and if imports are greater than exports then it is
unfavourable

causes of the BoP disequilibrium

Development Programmes
The direct impact of large scale development expenditures is seen in
increase the purchasing power, aggregate demand and prices. This results
in large scale imports. This phenomenon is common in developing
countries where large scale import of capital goods needed for carrying
out various development programmes and it will raisethe deficit in their
balance of payments. These developmental imports cause BoP
disequilibrium.
Cyclical Fluctuations
Cyclical fluctuations in the business activity bring depression,
stagnant and boom stage in world trade. Whenever there is a
depression/recession in foreign countries, our exports will fall due to low
demand and there will be reduction in foreign exchange earnings. This
will cause BoP disequilibrium. Similarly, the boom condition in foreign
countries will increase our exports and our capacity to earn foreign
exchange will increase.
Population growth
The high population growth of a country may lead to increased
imports due to increased demand. This will naturally cause the BoP
disequilibrium.
Natural factors
Natural calamities in the form of floods, no rains may affect the
agricultural and industrial production of a country. Then the country will
go for increased imports and reduced exports. This will cause
discrepancy in the equilibrium of the BoP.
Political Factors
A country with political instability may experience large capital
outflow and inadequacy of domestic investment and production.
Sustained Disequilibrium
The sustained or secular disequilibrium refers to a situation when,
the BoP disequilibrium persists for long periods due to certain secular
trends in the economy. It is seen in the developed countries where, the
disposable income is generally very high and so the aggregate demand is
also very high. But due to higher aggregate demands, the production
costs are also very high. This would result in higher prices, which may
result in the imports being much higher than exports.
Structural Disequilibrium
Structural Disequilibrium occurs due to changes in some sectors of the
economy at home country or foreign country which may alter the
demand-supply relations of exports or imports or both. The changes may
include development of alternative source of supply, development of
better substitutes, exhaustion of productive resources or change in
transport routes and costs etc.

MEASURES TO CORRECT DISEQUILIBRIUM IN THE BOP

1. Monetary Measures :

a) Monetary Policy The monetary policy is concerned with money

supply and credit in the economy. The Central Bank may expand or
contract the money supply in the economy through appropriate measures
which will affect the prices.

b) Fiscal Policy

Fiscal policy is government's policy on income and expenditure.

Government incurs development and non - development expenditure,. It
gets income through taxation and non - tax sources. Depending upon the
situation governments expenditure may be increased or decreased.

c) Exchange Rate Depreciation

By reducing the value of the domestic currency, government can correct

the disequilibrium in the BOP in the economy. Exchange rate
depreciation reduces the value of home currency in relation to foreign
currency. As a result, import becomes costlier and export become
cheaper. It also leads to inflationary trends in the country

d) Devaluation

devaluation is lowering the exchange value of the official currency.

When a country devalues its currency, exports becomes cheaper and
imports become expensive which causes a reduction in the BOP deficit.
MEASURES TO CORRECT DISEQUILIBRIUM IN THE BOP

e) Deflation

Deflation is the reduction in the quantity of money to reduce prices and

incomes. In the domestic market, when the currency is deflated, there is a
decrease in the income of the people. This puts curb on consumption and
government can increase exports and earn more foreign exchange.

f) Exchange Control

All exporters are directed by the monetary authority to surrender their

foreign exchange earnings, and the total available foreign exchange is
rationed among the licensed importers. The license-holder can import any
good but amount if fixed by monetary authority.
2. Non- Monetary measures :

a) Export Promotion

To control export promotions the country may adopt measures to

stimulate exports like: export duties may be reduced to boost
exports ;cash assistance, subsidies can be given to exporters to increase
exports ;goods meant for exports can be exempted from all types of taxes.

b) Import Substitutes

Steps may be taken to encourage the production of import substitutes.

This will save foreign exchange in the short run by replacing the use of
imports by these import substitutes.

c) Import Control

Import may be kept in check through the adoption of a wide variety of

measures like quotas and tariffs. Under the quota system, the government
fixes the maximum quantity of goods and services that can be imported
during a particular time period.

1. Quotas –
2. Under the quota system, the government may fix and permit the
maximum quantity or value of a commodity to be imported
during a given period. By restricting imports through the quota
system, the deficit is reduced and the balance of payments
position is improved.
3. Tariffs –
4. Tariffs are duties (taxes) imposed on imports. When tariffs are
imposed, the prices of imports would increase to the extent of
tariff. The increased prices will reduced the demand for imported
goods and at the same time induce domestic producers to produce
more of import substitutes