Module – 5

International Trade
 International Trade

• International trade is the exchange of goods and services between

countries. The exchanges can be imports or exports.
• Advantages of International Trade:
Optimal use of natural resources: Each country can concentrate on
production of those goods for which its resources are best suited.
Availability of all types of goods:It enables a country to obtain all
types of goods by importing from other countries at lower costs.
Specialisation:Foreign trade leads to specialisation and encourages
production of different goods in different countries.
Advantages of large-scale production:Due to international trade,
goods are produced not only for home consumption but for export
to other countries also. This leads to production at large scale
 Advantages
• Stability in prices:It equalizes the prices of goods throughout the
world.
• Deficiency in the supply of goods at the time of natural
calamities such as drought, floods, famine, earthquake etc can
be met by imports from other countries.
• Exchange of technical know-how and establishment of new
industries
• Due to international competition, the producers in a country
attempt to produce better quality goods and at the minimum
possible cost. This increases the efficiency
 Advantages & Disadvantages
• Development of the means of transport and communication:
• International co-operation and understanding
• Disadvantages of International Trade:
• International trade has an adverse effect on the
development of home industries.
• The underdeveloped countries have to depend upon the
developed ones for their economic development. Such
reliance often leads to economic exploitation.
 Disadvantages
• Excessive exports may exhaust the natural resources of a
country
• Import of Harmful Goods
• International trade gives an opportunity to foreign agents to
settle down in the country which ultimately endangers its
internal peace.
• International trade brings rivalries amongst nations due to
competition in the foreign markets.
• International trade promotes lopsided development of a
country
 Theories of International Trade

• Absolute Advantage Theory

• The concept of absolute advantage was developed by Adam
Smith . It states the importance of specialization in
production. Countries should specialize in producing the
goods and services in which they have absolute advantage and
engage in free trade with other countries to sell their goods. A
country’s resources would therefore be utilized in the best
possible way—in the production of goods and services in
which the country has a productivity advantage compared with
other countries
 Illustration
• To illustrate the idea of absolute advantage (AA) consider the following
table which gives the labor hours required to produce one unit of Cloth
and Wheat . England has AA in production of Cloth as it takes fewer hours
to produce a unit of Cloth than by Portugal. Since it takes less hours to
produce Wheat by Portugal , it has an AA in production of Wheat. Adam
Smith’s theory: Countries should specialize in the production of goods
in which they have an AA. So England will be better off if it specializes
in the production of Cloth and Portugal will be better off if it specializes in
Wheat. So they don’t need to produce both goods at home.
England Portugal

Cloth 2 10

Wheat 8 4
 Comparative advantage Theory: David Ricardo

• 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. This is basis of international trade,
according to Ricardo
 Assumptions & Illustrations
* Two countries *Two commodities *Only one factor- Labour *Labour is
homogeneous * Labour has perfect mobility
• Ricardo in his two country two commodity model took England and Portugal
as two countries and cloth and wine as two commodities. England has a
comparative cost advantage in the production of cloth, where as Portugal has
advantage over the production of wine.
Countries No. of units of labour / Unit of No. of units
cloth of labour /
Unit of Wine

England 100 120

Portugal 90 80
The Heckscher – Ohlin Theorem (H-O) or Factor Endowment Theory

• Heckscher – Ohlin Theorem states that relatively labor

abundant country will export the relatively labor-intensive
commodity and import the relatively capital – intensive
commodity. In this theorem factors of production are
considered as abundant or scarce in relative terms not in
absolute terms. A country will be considered capital abundant
if ratio of capital to other factors is higher when compared to
other countries.
Country A Country B
Supply of Labour= 50 Supply of Labour=16
Supply of Capital=40 Supply of Capital= 20
Capital-Labour ratio= .8 Capital- Labour ratio= 1.25
 Trade policy

• Trade policy can be defined as goals, rules, standards, and

regulations that are involved in the trade between countries.
The major 2 policies that the countries follow with respect to
international trade are
• Free Trade
• Protectionism
• Free Trade
• Free trade means free and unfettered trade between countries,
unhindered by steep tariffs, and where goods can pass over
borders unmolested by any restrictions. Free trade agreements
are contracts between countries to allow access to their
markets.
•
 Advantages of Free Trade

Increased economic growth: Free trade will increase the

production which lead to economic growth.
More dynamic business climate:Freely undertake trade with
other countries
Foreign direct investment: Attract foreign investors
Technology transfer: Local companies also receive access to
the latest technologies from their multinational partners.
Expertise: Global companies have more expertise than
domestic companies to develop local resources.
More choice of goods
– Improves Quality: Greater competition is also likely to
improve quality and choice.
 Disadvantages of Free Trade

• Threat to domestic industries.

• Import of harmful products
• Job outsourcing leads to unemployment in domestic
economy
• Poor working conditions: Multinational companies may
outsource jobs to emerging market countries without
adequate labor protections.
• Degradation of natural resources: Emerging market
countries often don’t have many environmental protections.
• Destruction of native cultures: As development moves
into isolated areas, indigenous cultures can be destroyed
 Protectionism
• Trade protectionism is a policy to protect domestic industries
from foreign competition.
• Advantages of Protectionism
• Infant Industry Argument - New industries in a country
need temporary protection from foreign competition.
• Strategic and key industry argument – By protecting the
strategic and key industries the economy is able to develop
other industries thereby economic development is possible.
• Anti dumping argument – By protective measures a
government can prevent dumping.
• National Defence - For our national security.
• Keeping money at home
• More growth opportunities
• Lower imports: Protectionist policies help to reduce import
levels
• More jobs: Higher employment by domestic firms.
• Higher GDP: Protectionist policies tend to boost the
economy’s GDP due to a rise in domestic production.
 Disadvantages of Protectionism

• Limited choices for consumers: Consumers have access to fewer

goods in the market.
• It discourages competition and hence compromises efficiency
• Growth of domestic monopolies
• Increase in prices (due to lack of competition): Consumers will
need to pay more
• Economic isolation: It often leads to political and cultural isolation,
which, in turn, leads to even more economic isolation.
• Stagnation of technological advancements: As domestic producers
don’t need to worry about foreign competition, they have no incentive
to innovate or spend resources on research and development (R&D)
of new products.
• Economic Loss: Protectionist policies impose an additional cost
 Trade Barriers
• Trade barriers refers to govt policies and measures which
restrict the free flow of goods between countries. Broadly
trade barriers are divided in to two groups- Tariff barriers and
Non –tariff barriers.
• Tariff Barriers
• Duties or taxes imposed by govt on its import or export.
• Classification
• A) On the basis of origin and destination of goods
• i) Export duties: Home Country
• ii) Import duties: Foreign Country
• iii) Transit duty: Tax on goods crossing the boundaries
 Tariff barriers
B) Based on Quantification
i) Specific duties: Tax on units
ii)Ad Valorem duties: Duty based on value
iii) Compound duties: Specific duties and ad valorem duties
C) Based on application of tariffs between countries
i) Single column tariff: Uniform tariff on similar products
ii) Double column tariff: Two rates are imposed
iii) Triple column tariffs: Three rates- general, intermediate and
preferential
D) Based on purpose
i)Revenue tariff: Generating revenue
ii)Protective tariff: Protect industries
iii)Anti- dumping tariff: To avoid dumping
Tariff Barriers
• In the diagram domestic demand curve is DD1 and
supply curve is SS1, intersects at point M and the
equilibrium price is P and quantity is Q. Under free
trade demand is P1B and supply is P1A, ie, Q1Q2
will be imported.Suppose the govt impose a tariff
equal to P2, domestic demand falls to Q4 and
domestic supply increases from Q1 to Q3 ie, Q3Q4
will be met by import. Under free trade consumer
surplus is DP1B and tariff reduces it to DP2G. Govt
get a revenue of CEFG.
 Tariff barriers
Effect of tariff
a) Protective effect: Protect domestic industries(Import become
costlier)
b) Revenue effect: Tariff will increase revenue
c) Income & employment: A tariff will increase production,
employment and income in the home country
d) Balance of payment effect: Tariff may help to improve the
BOP
e) Consumption effect: Import duty will increase the price of
commodities
f) Competitive effect : Reduce competitive effect
g) Redistribution effect: In favour of producers
 Non tariff barriers & Quotas
It includes a) Voluntary Export Restraints(restriction on export)
b) Administered protection like safe guards(domestic industry), implementing
health & product standard, licensing, foreign exchange regulations,
environmental protection laws etc
Quotas(Quantitative restrictions)
It represents a ceiling or limit on the volume of export & import.
Custom quota:
A specified quantity is allowed to be imported duty free or at a special low rate of
duty. A heavy rate on excess import.
Unilateral quota:
Absolute limit on import during a given period
Bilateral quota:
Through negotiation between countries quotas are set.
Mixing quotas :
Limits on the foreign made raw materials to produce commodities domestically
Import licensing
 Effect of Quotas
• Price effect: Domestic price increases
• Consumption effect: increase in price reduces
consumption
• Balance of payment position improves as a
result of restriction on import
• Protective effect: Protects domestic industries
• Revenue effect: from license fee
Effect of quota
 Tariff Vs Quotas
• Quota is more effective in regulating trade
• Quotas are more precise and certain in action
• Quotas can be imposed and removed easily
• Quotas can avoid recession induced imports
 Balance of payments(BOP)
The balance of payments summarizes the economic transactions
of an economy with the rest of the world. These transactions
include exports and imports of goods, services and financial
assets, along with transfer payments (like foreign aid).
The Components of the Balance of Payments
• There are three components of balance of payment viz current
account, capital account, and financial account (The official
reserve account).
Current Account
This account covers all the receipts and payments made with
respect to raw materials and manufactured goods. It also
includes receipts from engineering, tourism, transportation,
business services, stocks, and royalties from patents and
copyrights.
 Capital account
• There are 3 major elements of a capital account:
• Loans and borrowings – It includes all types of loans from both
the private and public sectors located in foreign countries.
• Investments – These are funds invested in the corporate stocks by
non-residents.
• Foreign exchange reserves – Foreign exchange reserves held by
the central bank of a country to monitor and control the exchange
rate does impact the capital account
• The Official Reserve Account
• The flow of funds from and to foreign countries through various
investments in real estates, business ventures, foreign direct
investments etc is monitored through the financial account.
 Disequilibrium in BOP
Economic Factors:
i) Development disequilibrium: Large development
expenditure may increase imports
ii) Cyclical disequilibrium: Boom & depression.
During boom , more demand
iii) Secular disequilibrium: Increase in aggregate
demand and high price leads to larger imports and
deficit in the BOP
 Disequilibrium
• Political factors
• Political instability may adversely affect the
capital flows and investments. It may leads to
larger capital outflows and less investment in
the domestic country.
• Social factors
• Changes in tastes , fashions, etc may change
consumption habits of people and this may
affect export and import
 Corrective measures
• 1. Automatic correction: With the help of
demand and supply mechanism. Eg. When
there is a deficit in BOP, exchange rate will be
get adjusted accordingly and there will be a fall
in the external value of the domestic currency.
This will increase export and correct the deficit.
• 2. Deliberate measures: it includes monetary
measures, trade measures and miscellaneous
measures.
 Corrective measures
• Monetary measures: Contraction & expansion in money
supply
• i) when there is deficit , a contraction in money supply will
decrease the purchasing power of the people and hence
aggregate demand and price level falls. This reduces import
and encourage export.
• Ii) Devaluation: It means a deliberate reduction in the value of
currency by reducing the official rate at which it is exchanged
for another currency. Devaluation encourage export and
discourage imports.
• Iii) Exchange control: Govt or RBI will have complete control
over the foreign exchange earnings of the country.
 Corrective measures
• Trade Measures
• Export promotion( by avoiding excise duties
and by providing subsidies) & import control
measures(imposing duties)
• Miscellaneous methods
• Encouragement of foreign investment &
promotion of tourism
 DEVALUATION
• A deliberate reduction in the value of domestic currency
in terms of foreign currencies. A country which faces a
serious problem of deficit in BOP may resort to
devaluation. This will stimulate their export and
discourage import. It can be explained with the help of
devaluation of Indian currency in 1966. Before
devaluation $1=4.76, during devaluation $1=7.5. It
means that before devaluation , a commodity which
causes $1in abroad and 4.76 in India, now cost only 0.64
for foreigners. Thus Indian goods become cheaper in
foreign market & encouraged export.
 Limitations
• Success of devaluation depends on reactions of
other countries
• If price in the domestic country increase at the
same rate or higher rate devaluation will not
increase export or decrease import.
The success of devaluation depends on elastici
ties of demand for export and import.ie, sum of
elasticities of demand for export and imports
of domestic country is greater than 1.