Trade Theory and Commercial Policy: Dr. Ch. Venkata Krishna Reddy Associate Professor

Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance
Trade theory and commercial policy
Dr. Ch. Venkata Krishna Reddy

Associate Professor
Session Plan
• Trade theory and commercial policy

– Theory of International trade
– Growth and trade
– Export-led growth
– Instruments of trade policy
– Trade policies for developing countries
04/05/2021 International Financial 2
Management
Why Go International
• There are several factor which motivate firm to go
international, but broadly divided into two groups
– Pull factor :- mean attractiveness of the foreign market due
to high profitability, growth opportunity
– Push factor :- mean compulsions like saturation in domestic
market.
04/05/2021 3
Reasons of International Trade

• Profit advantage
• Growth opportunities
• Domestic market constraints
• Competition
• Government policies and regulations
04/05/2021 4
Some more Reasons of International Trade

• There is an uneven distribution of natural resources in different countries. Therefore,
international trade exists to bridge the gap across geographical boundaries.
• All countries possess diverse strengths and weaknesses in terms of land, labour, capital and
technology. By focusing on industries with comparative advantage, cost and operations
efficiencies are reaped via specialization.
• It provides consumers the opportunity to be exposed to those goods and services that are not
available in their own country.
• It reduces dependency on domestic market by expanding customers’ demand in other countries.
• It enhances economic growth and contribute significantly to the country’s Gross Domestic
Product.
04/05/2021 5
Special problems in Int. Business

• Political and legal differences
• Cultural differences
• Economic differences
• Difference in currency unit
• Difference in language
• Trade and investment restrictions
• High cost of distance
• Tariff
04/05/2021 6
Driving forces of International Business

• Liberalization/ globalization
• MNCs
• Technology
• Transportation and communication revolutions
• Rising aspiration and wants
• Competition
• Regional integration
• Scale economies
04/05/2021 7
The Importance of Trade Theory

Trade theory helps managers and government policymakers focus on
three critical questions:
• What products should be imported and exported?
• How much should be traded?
• With whom should they trade?

04/05/2021 8
Various Trade Theories

• Interventionist Trade Theories
– Interventionist trade theories prescribe government action with respect to the
international trade process
• Mercantilism
• Neo mercantilism
• Free Trade Theories
– Free trade (a positive-sum game) implies specialization and requires that nations
neither artificially limit imports nor artificially promote exports.
• Absolute Advantage
• Comparative Advantage
• Other Theories Dr. Ch. Venkata Krishna Reddy
04/05/2021 9
Mercantilism
• Initial trade theory that formed the foundation of economic
thought from 1500 – 1800
• Based on concept that a nations wealth is measured by its
holding of treasure (gold)
• Nations often imposed restrictions on imports since they did
not want “their” treasure moving to another country to pay for
the imports
• It was also advantageous to run a trade surplus with “colonies”
04/05/2021 10
Mercantilism Terms
• Favorable balance of trade: country is exporting
more than it is importing
• Unfavorable balance of trade: country is importing
more than it is exporting, i.e. a trade deficit

04/05/2021 11
Neo-mercantilism
• current term to describe the approach of
countries that try to run favorable balances of
trade to achieve some social or political gains

04/05/2021 12
Absolute Advantage
• If one region can produce a commodity with less expense than another,
and they exchange, then both should benefit.
• Some land grows corn better than other land. This economical insight
into farming in early 18th Century was the cornerstone of the law of
absolute advantage. Some farmland will yield more corn per acre than
another, therefore the good land confers an absolute advantage over
other regions. The conclusion drawn from this argument is that the
farmer of the poor land should change products that it can produce to its
absolute advantage.
04/05/2021 13
Absolute Advantage
• The law of absolute advantage is based on the assumption that
competition is the best paradigm within which to build an economy, it
assumes that competition will improve production. The problem with the
use of this paradigm is that it creates winners and losers. In every
competition someone is excluded.
• Absolute advantage holds that different countries produce some goods
more efficiently than other countries
• Thus, global efficiency can be increased through international free trade
04/05/2021 14
Country Specialization
• Under the concept of absolute advantage countries
could increase efficiency because:
• Labor could become more skilled by repeating the same tasks
• Labor would not lose time in switching from the production of
one kind of product to another
• Long production runs would provide incentives for the
development of more effective working methods
04/05/2021 15
Natural Advantage
• Countries have inherent advantages

– Climate
– Natural resources
– Labor forces
• Two countries that have opposite natural advantages
should favor trade with one another
04/05/2021 16
Acquired Advantage
• Most contemporary trade is manufactured goods and services rather than
agricultural goods or natural resources
• An acquired advantage represents a distinct advantage in skills, technology, and
assets that yields differentiated products and/or cost-competitive products.
• Countries with an acquired advantage produce manufactured goods and
services competitively
– Product technology
– Process technology
04/05/2021 17
Absolute Trade Advantage

04/05/2021 18
Comparative Advantage
The law of comparative advantage says that within a country, a region will produce goods it
can make cheaper than other regions
That the value of a commodity within a country is determined by its labour, land, and
capital content. During the production life of a good, the supply will expand until the
price is levelled down to the total value of the labour, land, and capital that it contains.
Therefore a country should export the product in which it has the greater advantage, or
comparative advantage, and import the commodity in which its advantage is less, or in
which it has a comparative disadvantage.
Even when one country can produce both commodities more efficiently than another
country, both can gain from specialization and exchange, provided that the efficiency
advantage is greater in someDr.commodity or commodities
Ch. Venkata Krishna Reddy than in others.
04/05/2021 19
Comparative Advantage
• There are still global gains to be made if a country specializes in products it produces
more efficiently than other products
• Regardless of whether other countries can produce those same products even more
efficiently.
• Comparative Advantage: - A country can maximize its own economic well-being by

specializing in the production of those goods and services it can produce relatively
efficiently and enhance global efficiency through its participation in unrestricted
free trade.
04/05/2021 20
Factor Endowments and the Heckscher-Ohlin Theory
• Adam Smith and David Ricardo assumed that each country would
have its own technology, climate, and resources, and that these
differences would give rise to productivity differences (and thus
differences in comparative advantage)
• According to 20th century economists, productivity differences
between countries arise from differences in the factors of production
04/05/2021 21
Heckscher-Ohlin (HO) Theory

• Argument: A country’s factors of production (country’s endowments of inputs)
used to make each good give rise to productivity differences between countries
– Factor abundance(Rich) versus factor scarcity: when a country enjoys a relative
abundance of a factor, the factor’s relative cost is less than in countries where the factor is
relatively scarce
– A country’s comparative advantage lies in the production of goods that use relatively rich
factors
– The composition of a country’s trade depends on both its natural and acquired advantages.

04/05/2021 22
Assumptions of the Theory
1) There are two nations (1&2), two commodities (X&Y), two factors of production
(labor & capital).
 Used to illustrate the theory in a two-dimensional figure.
2) Both nations use the same technology in production.
 Means both nations have access to and use the same general production techniques.
3) Commodity X is labor intensive and Y is capital intensive in both nations.
 Means the labor-capital ratio (L/K) is higher for X than Y in both nations at the same
relative factor prices.
04/05/2021 23
4) Both commodities are produced under constant returns to scale in both

nations.
 Means that increasing the amount of L and K will increase output in the same
proportion
5) There is incomplete specialization in production in both nations.
 Means that even with free trade both nations continue to produce both
commodities. This implies neither nation is very small.
6) Tastes are equal in both nations.
 Means demand preferences are identical in both nations. When relative prices are
equal in the two nations, both consume X&Y in the same proportion.
04/05/2021 24
The standard trade theory
combines ideas from the Ricardian model and the

Heckscher-Ohlin model.
 differences in labor services, labor skills, physical capital, land, and technology
between countries cause productive differences, leading to gains from trade.
 these productive differences are represented as differences in production possibility
frontiers, which represent the productive capacities of nations.

Management
THE NEW TRADE THEORY

a firm or industry may have increasing returns to scale or economies of scale:
When factors of production change at a certain rate, output increases at a faster rate.
A larger scale is more efficient: the cost per unit of output falls as a firm or industry increases output.
but when economies of scale exist, large firms may be more efficient than small firms, and the industry may consist of a monopoly or a
few large firms.
Production may be imperfectly competitive in the sense that excess or monopoly profits are captured by large firms.
Economies of scale could mean either that larger firms or a larger industry is more efficient.
External economies of scale occur when cost per unit of output depends on the size of the industry.
Internal economies of scale occur when the cost per unit of output depends on the size of a firm.

04/05/2021 26
International Financial Management
Trade and growth

the most important question is ”Does more trade lead to growth?”
channels through which trade affects economic growth are GDP, income distribution, poverty, and employment.
trade can be an important stimulus to rapid economic growth by promoting greater utilization of idle human and
capital resources, increasing foreign exchange earnings, and expanding access to technological knowledge.
for a majority of developing countries, the principal benefits of world trade have accrued disproportionately to
foreign residents and wealthy nationals
this is because the bargaining power is concentrated in the hands of developed country private and public
institutions and wealthy nationals
Trade, because of its biased distributional effects, may often tend to reinforce existing inequalities rather than serve
development objectives.

04/05/2021 27
Export led growth
the export-led growth hypothesis(ELGH) states countries can achieve economic growth through export.
it was particularly the characteristic of development of the Asian Tigers: Hong Kong, South Korea, Taiwan,
and Singapore
Export enhances growth by
Creating profit allows a country to balance its finances as well as surpass its debts as long as the facilities
and materials for the export exist.
Increasing productivity

TYPES OF EXPORTS
Manufactured Goods
is the most common way to achieve export-led growth
but industries compete against industries in advanced economies, which often include better technology, better educated workers,
and more capital to start with
Raw Materials/primary goods
it has a considerable amount of risk compared to manufactured goods.
Low income and price elasticity of demand
the terms of trade greatly affect this plan.
For instance, price of coffee has been declining at

an annual rate of 0.77% for approximately 300 years!

04/05/2021 29
International Financial Management
Export led growth

04/05/2021 30
Export led growth

Ethiopia China
Exports $1.716 billion $1.581 trillion
Imports $6.992 billion $1.327 trillion
Export goods Coffee, qat, gold, leather products, live electrical and other machinery, including
animals, oilseeds data processing equipment, apparel,
textiles, iron and steel, optical and medical
equipment
Export trade China 13.9%, Germany 10.5%, Belgium US 18%, Hong Kong 13.8%, Japan 7.6%,
Source: CIA world factbook(https://www.cia.gov)
partners 7.5%, Saudi Arabia 7.1%, US 6.8%, Sudan
4.6%
South Korea 4.4%, Germany 4.3

04/05/2021 31
Instruments Of Trade Policy

The main instruments of trade policy are:
•Tariffs
•Subsides
•Import Quotas
•Voluntary Export Restraints
•Local Content Requirements
•Administrative Polices
•Antidumping Policies
04/05/2021 32
Tariffs
• Tariffs are the oldest form of trade policy; they fall into two categories:
• Specific tariffs are levied as a fixed charge for each unit
• Ad valorem tariffs are levied as a proportion of the value of the imported good
• Tariffs are good for government because they generate revenue.
• But, while they protect domestic producers but they reduce efficiency, and create
higher prices for consumers.

04/05/2021 33
Methods of calculation of Tariff payable

• After Tariff liability is established and after the product is correctly
classified, the next question is how Tariff is payable
– Tariff is payable by following methods
• specific duty based on some measure like weight, volume, length etc.
• Duty as % of tariff value fixed by the authority
• Duty based on MRP printed after allowing some deductions
• Compounded levy scheme
• Duty as % based on assessable value fixed under ad valorem duty
04/05/2021 34
Specific duty
• It is duty based on some measure like weight, volume, length etc.
for example duty on cigarette is payable on the basis of length,
duty on sugar on the basis on per Kg basis etc. in such cases
calculation of duty is comparatively easy. Because it is simple
method so earlier most of the product covered under this but due
the disadvantage of this method that even selling price is increase
duty not increase hence now most of product are covered under ad
valorem duty.
04/05/2021 35
Tariff value
• In some case tariff value fixed by govt. this is notional
value for the purpose of calculating the duty. Provision
of fixing tariff value is used vary rarely. Such value can
be fixed only on few selected commodities. Like pan
masala packed in retail packs of up to 10 gm per pack.

04/05/2021 36
Compounded levy scheme

• Normal excise procedure and controls are not practicable when
there are numerous small manufacturers. Under compounded levy
scheme the manufacturer has to pay prescribed duty for specified
period on the basis of certain factors relevant to production, size of
equipment etc. after making lump sum periodic payment the
manufacturer does not follow any procedure of excise regarding
storage and clearance of goods. The scheme is presently applicable
only to stainless steels plant. These article are not eligible for SSI
exemption.
04/05/2021 37
Value based on MRP basis

• The provision for valuation on MRP basis are as follow
– The goods are covered under standard of weight and measure ACT 1976.
– The notified goods on which the excise duty is chargeable are entitled to
get abetment prescribed by the govt.
– If more than one MRP is shown at the packet than highest price shown on
the package is considered as MRP
– Goods which are valued on MRP basis are biscuits, mineral water,
toothpaste, thinner etc.
04/05/2021 38
Duty as % based on assessable value ( ad valorem duty)
• Assessable value (AV)- AV is the value on which duty is

payable as a percentage generally by value we
understand the price as mentioned in Bill or Invoice.
– Duty is payable even if goods are not sold
– It is desirable to have uniform policy in fixing AV
– Chances of manipulation in such price should be minimum.
04/05/2021 39
Subsidies
• Subsidies are government payments to domestic producers. They can be in the form of:
• Cash grants
• Low-interest loans
• Tax breaks
• Government equity participation in the company
• Subsidy revenues are generated from taxes.
• Subsidies encourage over-production, inefficiency and reduced trade.

•Consumers typically absorb the costs of subsidies
Subsidies help domestic producers in two ways:

•they help them compete against low-cost foreign imports
•they help them gain export markets

04/05/2021 40
Import Quotas And Voluntary Export Restraints

•Import quotas directly restrict the quantity of some good that may be imported into a country
•Tariff rate quotas are a hybrid of a quota and a tariff where a lower tariff is applied to imports
within the quota than to those over the quota
•Voluntary export restraints are quotas on trade imposed by the exporting country, typically at
the request of the importing country’s government
•A quota rent is the extra profit that producers make when supply is artificially limited by an
import quota
•Import quotas and voluntary export restraints benefit domestic producers by limiting import
competition, but they raise the prices of imported goods

04/05/2021 41
Local Content Requirements
•A local content requirement demands that

some specific fraction of a good be produced
domestically
•Local content requirements benefit domestic
producers, but consumers face higher prices
04/05/2021 42
Administrative Policies
•Administrative trade polices are bureaucratic rules

that are designed to make it difficult for imports to
enter a country
•These polices hurt consumers by denying access to
possibly superior foreign products
04/05/2021 43
Antidumping Policies
•Dumping refers to selling goods in a foreign market below their costs of production, or
selling goods in a foreign market below their “fair” market value
•Dumping enables firms to unload excess production in foreign markets
•Some dumping may be predatory behavior, with producers using substantial profits
from their home markets to subsidize prices in a foreign market with a view to driving
indigenous competitors out of that market, and later raising prices and earning
substantial profits
•Antidumping polices (or countervailing duties) are designed to punish foreign firms that
engage in dumping and protect domestic producers from “unfair” foreign competition
04/05/2021 44
Trade Policy in Developing Countries
Three alternative policies

Import substituting industrialization
Trade liberalization
Export oriented industrialization

04/05/2021 45
IMPORT SUBSTITUTING INDUSTRIALIZATION
The principal justification of this policy was/is the infant industry argument:
Countries may have a potential comparative advantage in some industries, but these industries can not initially compete with well-
established industries in other countries.
Governments should temporarily support them
until they have grown strong enough to compete internationally.
Problems With the Infant Industry Argument
1. It may be wasteful to support industries now that will have a comparative advantage in the future.
2. With protection, infant industries may never “grow up” or become competitive.
3. there is no justification for government intervention unless there is a market failure that prevents the private sector from investing in
the infant industry
Did import substituting industrialization promote economic development?
No, countries adopting these policies grew more slowly than rich countries and other countries not adopting them.
04/05/2021 46
TRADE LIBERALIZATION
by the mid-1980s many governments had lost faith in import substituting industrialization and began
to liberalize trade.
has trade liberalization promoted development?
The evidence is mixed. Growth rates in Brazil and other Latin American countries have been
slower since trade liberalization than the were during import substituting industrialization,
Other countries like India have grown faster since liberalizing trade in the 1980s, but it is unclear
to what degree liberalized trade contributed to growth

04/05/2021 47
EXPORT ORIENTED INDUSTRIALIZATION
Instead of import substituting industrialization, several countries in East Asia adopted trade policies that promoted
exports in targeted industries.
Japan, Hong Kong, Taiwan, South Korea, Singapore, Malaysia, Thailand, Indonesia and China are
countries that have experienced rapid growth in various export sectors and rapid economic growth in general.
It is also unclear if the high volume of exports and imports caused rapid economic growth or was merely correlated
with rapid economic growth.
Some economists argue that the cause of rapid economic growth was high saving and investment rates,
leading to both rapid economic growth in general and rapid economic growth in export sectors.
In addition, almost of the high performance Asian economies have experienced rapid growth in education,
leading to high literacy and numeracy rates important for a productive labor force.
04/05/2021 48
Thank you

04/05/2021 49

Trade Theory and Commercial Policy: Dr. Ch. Venkata Krishna Reddy Associate Professor

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Ethiopian Civil Service University, Addis Ababa

MSc. In Accounting and Finance

Trade theory and commercial policy

Dr. Ch. Venkata Krishna Reddy

• Trade theory and commercial policy

Reasons of International Trade

Some more Reasons of International Trade

Special problems in Int. Business

Driving forces of International Business

The Importance of Trade Theory

Dr. Ch. Venkata Krishna Reddy

Various Trade Theories

Dr. Ch. Venkata Krishna Reddy

Dr. Ch. Venkata Krishna Reddy

• Countries have inherent advantages

Absolute Trade Advantage

Dr. Ch. Venkata Krishna Reddy

• Comparative Advantage: - A country can maximize its own economic well-being by

Factor Endowments and the Heckscher-Ohlin Theory

Heckscher-Ohlin (HO) Theory

Dr. Ch. Venkata Krishna Reddy

Assumptions of the Theory

4) Both commodities are produced under constant returns to scale in both

The standard trade theory

combines ideas from the Ricardian model and the

Dr. Ch. Venkata Krishna Reddy

THE NEW TRADE THEORY

Dr. Ch. Venkata Krishna Reddy

Trade and growth

Dr. Ch. Venkata Krishna Reddy

Export led growth

Dr. Ch. Venkata Krishna Reddy

For instance, price of coffee has been declining at

Dr. Ch. Venkata Krishna Reddy

Export led growth

Dr. Ch. Venkata Krishna Reddy

Export led growth

Dr. Ch. Venkata Krishna Reddy

Instruments Of Trade Policy

• Tariffs are good for government because they generate revenue.

Dr. Ch. Venkata Krishna Reddy

Methods of calculation of Tariff payable

Dr. Ch. Venkata Krishna Reddy

Compounded levy scheme

Value based on MRP basis

Duty as % based on assessable value ( ad valorem duty)

• Assessable value (AV)- AV is the value on which duty is

• Subsidy revenues are generated from taxes.

• Subsidies encourage over-production, inefficiency and reduced trade.

Subsidies help domestic producers in two ways:

Dr. Ch. Venkata Krishna Reddy

Import Quotas And Voluntary Export Restraints

Dr. Ch. Venkata Krishna Reddy

Local Content Requirements

•A local content requirement demands that

•Administrative trade polices are bureaucratic rules

Trade Policy in Developing Countries

Three alternative policies

Dr. Ch. Venkata Krishna Reddy

IMPORT SUBSTITUTING INDUSTRIALIZATION

Dr. Ch. Venkata Krishna Reddy

EXPORT ORIENTED INDUSTRIALIZATION