Lecture 10

International Trade and

Balance of Payment
Distinction between Domestic
Trade and International Trade
• Different Units of Currency
• Greater specialization
• Documentation
• Size of Market
• Composition of Goods available in the market
• Distance oriented expenses
• Trading Barriers
 Theory of Comparative Advantage
• David Ricardo: Principles of Political Economy
(1817).
• He states that if there are two countries, a country
should specialize in the production of good or
service in which it has the greater comparative
advantage or the lower opportunity cost and
import commodities where the opportunity cost is
higher or comparative advantage is less.
Comparative Advantage and the Gains from Trade
Each
Resources (Cost) Required to Produce 1 Ton of Cocoa and Rice
Country
has $200 Cocoa Rice
for Cost Ghana $10 $13.33
S. Korea $40 $20
Maximum Production without Trade spending $100 on each product
Ghana 10.0tons 7.5 tons
S. Korea 2.5tons 5.0 tons
Total production 12.5 12.5
Production with Specialization
Ghana 15 ($150) 3.75 ($50)
S. Korea 0.0 10.0 ($200)
Total production 15 13.75
Consumption after Ghana Trades 4T of Cocoa for 4T South Korean Rice
Ghana 11 7.75
S. Korea 4 6
Increase in Consumption as a Result of Specialization and Trade
Ghana 1.0 0.25
S. Korea 1.5 1.0 Table 4.2
Advantages of International
Trade
1. There is an increase in world output and gains for the
individual country as a result of specialization and
trade.
2. There is wider customer choice as a result of
international trade. There is a great variety of goods
and services to choose from. This will improve general
living standard.
3. International trade generate income and brings about
higher economic growth .
4. International trade promotes travel and understanding
through cultural exchanges, visits and consultations.
Advantages of International
Trade
5. International trade brings about sharing of new
knowledge and information.
6. Due to International trade, there will be keen
competition which forces firms to be cost
effective and cost efficient.
7. International trade will prevent the formation of
Monopoly.
8. International trade leads to proper resource
allocation keeping in mind the comparative
advantage theory.
Disadvantages of International
Trade
1. If comparative advantage theory is followed,
country will start depending on other countries.
2. The export of raw material such as oil will one
day lead to the depletion of such raw material.
3. International trade leads not only to economic
but also political interdependence.
4. If transportation cost is very high, then it will not
be profitable to trade.
Protectionism
• Adam Smith advocated free trade, trade with no
restrictions at all. He believed that free trade will
bring about benefits and greater specialization. In
recent years free trade is almost impossible.
Protectionism
• Ways of Protecting Home Industries:
1. There are two type of taxes and tariffs on
imported goods.
a. Ad valorem Tax: Tax which is calculated in terms of
value.
b. Specific Tax: Tax which is calculated in terms of units.
Protectionism
2. By Imposing Quotas: Limiting the quantity of
goods that can be imported or exported.
Residents have to buy local products.
3. An Embargo: Setting a total ban on the goods
which are not allowed to the imported in to the
country.
4. Subsidies and grants: such as support given to
local producers to maintain cost of production so
that the prices reduces in the local market.
Protectionism
5. Preferential Treatment is the granting of
privileges of certain countries
6. The refusal to issue licenses to importers.
Balance Of Payment
A record of international transactions between
residents of one country and the rest of the world
International transactions include exchanges of
goods, services or assets
“Residents” means businesses, individuals and
government agencies, including citizens
temporarily living abroad but excluding local
subsidiaries of foreign corporations
Balance of Payments
• In short, it is calculated by adding up the value of all
the goods that are exported (i.e. sold to other
countries) and imported (i.e. bought from other
countries). It is made up by a combination, in a
country, of:
• The current account
• The capital account
• Official financing account
 The Current Account
The current account is made up of different components which
aggregate to give a final balance.
• Trade in goods
Items that include the import and export of finished goods, semi-
finished goods, and component parts for assembly.
• Trade in services
These services include tourism, financial services and consultancy.
• Investment income
Overseas activity that leads to a flow of money back to the
country. For example, interest received from direct investment,
the activities of subsidiaries, and dividends earned from owning
shares in foreign firms.
• Transfers
Items moved between countries such as overseas aid.
 Capital and Financing Account
• These accounts record the flow of capital and finances
between the domestic country and the rest of the world.
These types of flows include:
• Capital transfers related to purchase and sale of fixed assets
such as real estate
• Real foreign direct investment: a domestic firm setting up a
factory in another country, and earning money from that.
• Portfolio investment: a domestic investor buying share,
bonds etc. in a business that is already established. Such
investors have no control over these companies.
• Reserve assets: It means sell of financial instruments in the
foreign country. Central Bank will use foreign financial assets
to cover deficits and imbalances.
Balance of Payment Disequilibrium
• In theory, the two accounts should balance
completely; however in practice, this doesn’t
always happen. When the balance of payment is
not balanced, it is said to be in a state of
disequilibrium.
Balance of Payment Deficit
• If a country has a balance of payments deficit, this is
probably owing to them importing more goods and
services than it exports. It will therefore need to borrow
from another country to pay for the imports.
• This can be a useful strategy for fueling economic
growth; however it is not sustainable in the long term.
• In order to redress the imbalance, a country may have
to sell off assets and other natural resources, in order to
pay for its consumption. This too cannot last forever.
Balance of Payment Surplus
• A country in this position is likely to export much of
their production. Additionally, the individuals and
government within the country are likely to be high
savers, in order to provide enough capital to finance
production, and lend to other countries.
• This scenario works for short term economic growth;
however for longer term prosperity, individuals need to
increase domestic consumption, by switching from
saving.
• By creating domestic demand, the country will be less
reliant on export-led growth, and will be able to better
sustain itself.
Current Account Deficit
• A much discussed economic situation that countries
often find themselves in is a current account deficit.
Here we shall look in some detail at the scenario.
• What is a current account deficit?
• Running a deficit means that there is a net outflow of
demand versus the income that comes into a country.
This can be thought of as a country “not paying their
way”.
• The current account isn’t required to balance, because
the capital account can run a surplus. As we have seen
though, running a surplus is sometimes dependent on
selling reserve assets, and other unsustainable means.
Causes of Current Account Deficit
• There can be many factors across the economy that mean
a current account deficit is likely to occur. For example:
• High income elasticity of demand for imports: with
strong consumer spending, the volume of imports will
increase swiftly.
• Long term decline in manufacturing potential: with a
fall in the productive potential of an economy, it is less
likely that goods can be produced and exported.
• Changes in commodity prices: if a country imports a
high portion of raw material, if these prices swing
drastically, then this will increase the current account
deficit.
Balance of Payment Vs. Balance of
Trade
• We have seen so far that there is a difference in the
types of good that are included in the broad
balance of payments equation.
• To clarify, a large portion of the balance of
payments calculation, is the measure of balance of
trade.
• Balance of trade: is concerned with the trade of
visible goods (i.e. material goods)
• Balance of payments: is more thorough as it
includes not just visible goods, but also invisible.
Visible and Invisible Goods
• Visible goods
These can be recorded through customs duties and
their value can be measured. Visible goods will include
anything tangible, including cars, Machines and shoes.
• Invisible goods
These goods are often intangible, and include things
like financial services, insurance and capital flows.
They are harder to comprehend, but still represent the
flow of money in and out of an economy.
Thank You