International Economics I (N)

International Economics I Econ 3081
COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS
International Economics I
Course Code: Econ 3081
Compiled By: Wondimu W.(MSc.)
December, 2023
Bonga, Ethiopia
Bonga University, Economics Department i

Table of Contents
CHAPTER ONE ............................................................................................................................................................ 1
1.1. The subject matter of international economics .................................................................................................. 1
1.1.2. Nature and Scope of International Economics.............................................................................................. 1
1.2. The Components of International Economics.................................................................................................... 2
1.3. The Importance of International Economics...................................................................................................... 3
1.4. International Economics and Economic Theories ............................................................................................. 4
1.5. Purpose of Economic Theories and Models ...................................................................................................... 5
1.6. Testing a Hypothesis /theory/Models ................................................................................................................ 5
1.7. International trade theory and policy ................................................................................................................. 5
1.8. Reasons for international trade and its significance........................................................................................... 6
1.9. Current international economic problems .......................................................................................................... 7
CHAPTER TWO ........................................................................................................................................................... 8
2.1. Pre-Classical theory of International Trade (Mercantilism) .............................................................................. 8
2.2. The Classical Theory of International Trade ................................................................................................. 8
2.2.1 Adam Smith’s theory of Absolute Advantage ............................................................................................... 9
2.2.2 David Ricardo's Comparative Advantage Model ........................................................................................ 14
2.2.3 Law of Reciprocal Demand Offer curve Analysis ....................................................................................... 18
3. THE MODERN THEORY OF INTERNATIONAL TRADE ........................................................................ 21
3.1 The H-O Theorem (Factor-Endowment theory) .............................................................................................. 22
CHAPTER THREE INTERNATIONAL TRADE POLICY ...................................................................................... 30
3.2. Arguments in Favour of and Against Trade Protection ................................................................................... 31
3.2.2. Cases For free trade ..................................................................................................................................... 31
3.3. Optimal Trade Policy Intervention .................................................................................................................. 37
3.4. The Process of Trade Liberalization ................................................................................................................ 37
3.5. The Political Economy of Protection ............................................................................................................... 37
3.5.1. Arguments Against protection ..................................................................................................................... 38
3.5.2. Tariff and Its EffectsWhat is tariff? ............................................................................................................. 39
3.5.2.1. Effects of import tariff on tariff imposing country .................................................................................. 40
3.5.3. Non-tariff barriers ........................................................................................................................................ 40
3.5.3.1. Import quota............................................................................................................................................. 41
3.5.3.2. Tariffs versus quotas ................................................................................................................................ 42
3.5.3.3. Subsidies .................................................................................................................................................. 43
3.6. Intellectual Property and Intellectual Property Rights ..................................................................................... 46
CHAPTER FOUR ....................................................................................................................................................... 48
TRADE, GROWTH AND DEVELOPMENT ............................................................................................................ 48
Bonga University, Economics Department ii
4.1. Trade Strategies for Development: Export Promotion versus Import Substitution ......................................... 48
4.2. Export Promotion: Looking Outward and Seeing Trade Barriers ................................................................... 50
4.3. The Theory of Protection ................................................................................................................................. 54
4.4. Summary and Conclusions: Trade Optimists and Trade Pessimists ................................................................ 58
CHAPTER FIVE ......................................................................................................................................................... 62
5.1 Objectives of the chapter ................................................................................................................................. 62
5.2 Types of regional trading arrangements .......................................................................................................... 62
5.3 The Status of Regional Economic Integration in Africa .................................................................................. 63
5.4 Reasons for Regionalism ................................................................................................................................. 65
5.5. Effects of a regional trading Arrangement........................................................................................................... 66
5.6. International Trade regulations ........................................................................................................................ 70
5.6.2. World Trade Organization (WTO) .............................................................................................................. 73
5.6.3. Differences between WTO and GATT ........................................................................................................ 74
Bonga University, Economics Department iii

CHAPTER ONE
THE SUBJECT MATTER OF INTERNATIONAL ECONOMICS
1.1. The subject matter of international economics

1.1.1. Meaning of International Economics
What is International economics?
International economics is a branch of applied economics that deals with the economic
interaction of one nation (country) with other nations. Particularly;
 It studies how a number of distinct economies interact with one another in the process of
allocating scarce resources to satisfy human wants.
 Is study of international forces that influence the domestic conditions of an economy and
 Shape the economic relationship between countries
 It studies the economic interdependence between countries and its effects on economy.
1.1.2. Nature and Scope of International Economics
The scope of international economics is wide as it includes various concepts, such as
 globalization,
 gains from trade,
 pattern of trade,
 Balance of payments and FDI.
Apart from this, international economics describes
 production
 trade, and
 Investment between countries.
Generally, the economic activities between nations differ from activities within nations. For
Bonga University, Economics Department 1
example,
 The factors of production are less mobile between countries due to various restrictions
imposed by governments. The impact of various government restrictions on
 Production
 Trade
 consumption, and
 Distribution of income is covered in the study of internal economics.
Thus, it is important to study the international economics as a special field of economics.
1.2. The Components of International Economics

The subject matter of International Economics comprises a large number of segments
which, in turn, can be divided into several parts.
Broadly speaking, however, international economics covers the following main
components.
1. Pure Theory of Trade: It tries to explain the
 reasons for international trade in goods and services,
 determination of the composition,
 direction and volume of trade;
 determination of the terms of trade between exports and imports of a country;
 determination of rate of exchange and changes in it;
 concepts and issues relating to balance of trade and balance of payments, as also
the concepts of their equilibrium and disequilibrium.
2. Policy Issues: This portion of international economics covers a wide area of relevant
questions and a choice of associated policy alternatives. Examples include
a. free trade vs protection,
b. methods of regulating trade, capital and technology flows,
c. use of taxation, subsidies and dumping;

d. exchange control and convertibility,

e. issues relating to foreign aid, external borrowings and direct foreign investment,
f. Alternative measures of correcting balance of payments disequilibrium and the
like.
3. International Cartels and Trade Blocs, etc: Opening up of international trade and
economic flows is accompanied by attempts, with
 Varying degrees of success, of economic integration in the form of
international cartels, customs unions, monetary unions, trade blocs,
economic unions and so on.
4. International Financial and Trade Regulatory: After the Second World War, a
number of international financial and trade-regulatory institutions have come
into existence.
 They are deeply influencing international economic-transactions and relations and,
for this reason, their study should be considered a part of international economics.
1.3. The Importance of International Economics

International economics is growing in importance as a field of study because of
 The rapid integration of international economic markets. Increasingly, businesses,
consumers, and governments realize that their lives are affected not only by what goes on in
their own town, state, or country but also by what is happening around the world.
 Consumers can walk into their local shops today and buy goods and services from all over
the world. Local businesses must compete with these foreign products. However, many of
these same businesses also have new opportunities to expand their markets by selling to a
multitude of consumers in other countries. The advance of telecommunications is also
rapidly reducing the cost of providing services internationally, while the Internet will
assuredly change the nature of many products and services as it expands markets even
further.

1.4. International Economics and Economic Theories

Ever since 19th-century economists put forth their theories of international economics, the
subject has consisted of two distinct but connected parts: (1) the ―pure theory of international
trade,‖ which seeks to account for the gains obtained from trade and to explain how these gains
are distributed among countries, and (2) the ―theory of balance-of-payments adjustments,‖ which
analyzes the workings of the foreign exchange market, the effects of alterations in the exchange
rate of a currency, and the relations between the balance of payments and level of economic
activity.
In modern times, the Ricardian pure theory of international trade was reformulated by American
economist Paul Samuelson, improving on the earlier work of two Swedish economists, Eli
Heckscher and Bertil Ohlin. The so-called Heckscher-Ohlin theory explains the pattern of
international trade as determined by the relative land, labor, and capital endowments of
countries: a country will tend to have a relative cost advantage when producing goods that
maximize the use of its relatively abundant factors of production (thus countries with cheap labor
are best suited to export products that require significant amounts of labor).
This theory subsumes Ricardo‘s law of comparative costs but goes beyond it in linking the
pattern of trade to the economic structure of trading nations. It implies that foreign trade is a
substitute for international movements of labor and capital, which raises the intriguing question
of whether foreign trade may work to equalize the prices of all factors of production in all
trading countries. Whatever the answer, the Heckscher-Ohlin theory provides a model for
analyzing the effects of a change in trade on the industrial structures of economies and, in
particular, on the distribution of income between factors of production. One early study of the
Heckscher-Ohlin theory was carried out by Wassily Leontief, a Russian American economist.
Leontief observed that the United States was relatively rich with capital. According to the theory,
therefore, the United States should have been exporting capital-intensive goods while importing
labor-intensive goods. His finding, that U.S. exports were relatively more labor-intensive and
imports more capital intensive, became known as the Leontief Paradox because it doubtful the

Heckscher-Ohlin theory. Recent efforts in international economics have attempted to refine the
Heckscher-Ohlin model and test it on a wider range of empirical evidence.
1.5. Purpose of Economic Theories and Models

The purpose of economic theory in general is to predict and explain. That is, economic theory
abstracts from the details surroundings an economic event in order to isolate the few variables
and relationships deemed most important in predicting and explaining the event. Along these
lines, international economic theory usually assumes the two-nations, two-commodity and two-
factor world. It further assumes no trade restrictions to begin with, perfect mobility of factors
within the nations but no international mobility, perfect competition in all commodity and factor
markets and no transportation costs.
These assumptions may seem disproportionately restrictive. However, most of the conclusions
reached on the basis of these simplifying assumptions hold even when they are relaxed to deal
with a world of more than two nations, two commodities, and two factors, and with a world
where there is some international mobility of factors, imperfect competition, transportation costs
and trade restrictions.
1.6. Testing a Hypothesis /theory/Models

There are 6 economic theories under International Trade Law which are classified in four: (I)
Mercantilist Theory of trade (II) Classical Theory of trade (III) Modern Theory of trade
(IV) New Theories of trade. Both of these categories, classical and modern, consist of several
international theories. We will discuss them in detail in the Next Chapter.
1.7. International trade theory and policy

As a distinct branch of international economics, International trade theory and policy deals with
such issues as what governs the direction of trade between nations (factors that determine the
import and export commodities of nations), the potential gains from trade, and reasons for and
effects of different trade and commercial polices that govern movement of goods, services and
factors of production among nations.

International trade is treated as a separate subject from domestic trade. This is due to reasons
mentioned blow. By definition, international trade (also called foreign trade) is trade between
nations i.e. trade that crosses national boundaries of nations. On the other hand, domestic trade
(also called, home trade) includes trade between different regions or individuals of one nation.
There is a fundamental difference between these two types of trade.
First, movement of goods and services from one nation to another are subjected to different
commercial policies (such as tariff, quota, etc), whereas, there is almost nothing that governs
movement of goods and services from one place (region) to another in one nation, Second, factor
inputs such as labor and capital move freely within a country but not between different countries.
Moreover, different national policies, different political units, and different monetary systems
involved in international trade distinguish it from domestic trade.
1.8. Reasons for international trade and its significance

Is it really significant to trade for nations?
Would it be possible for the world community to live a more happy and prosperous
life in the absence of international trade?
In general, the immediate cause for trade among nations is difference in the prices of goods and
services among nations. Though it is the essential part of the overall course (and will be
discussed in detail in the next chapters), there are different reasons for the difference in the prices
of a commodity among nations. Nations differ in resource endowments, the level of technology
and technical skills or know how. For instance, Ethiopia imports computers from abroad because
she lacks the technology of production, capital and know how necessary for computer
production. The implication is that even if Ethiopia imports the technology and skill these factors
lead to high production cost and prices. This motivates domestic residents to prefer foreign
computers. Hence, it is worth for the country to import computers cheaply from a broad rather
than producing it at home at a higher cost. Moreover, nature has distributed resources unevenly
in the world which makes production of some goods in some countries impossible.

Thus, international trade has enabled the world nation to consume those goods and services
which they themselves could not produce.
1. It helps domestic firms to exploit economies of large scale production through expanding
markets. etc.
2. Each trading nation will gain as a world output increases because of specialization and
division of labor. The gains are in the form of more aggregate production, large number
of varieties, and greater diversity of qualities of goods.
3. Cultural exchange and ties among different countries develop when they inter in to
mutual trading.
4. International trade relations help in harmonizing international political relations.
5. It makes possible the most efficient use of the world resource through encouraging
specialization or division of labor among nations of international trade to the world
society.
1.9. Current international economic problems

Dear students! We have seen reasons for international trade &its significance. Now let‘s see
current international economic problems. The most important international economic
problems facing the world today are listed below. These are the problem that the study of
international economic theories and policies can help us understand and resolve. They are:
 The rising protectionism in industrial countries and the tendency of the world to break up
in trading blocs.
 The excessive volatility of exchange rates and their large and persistent misalignments
 Large and persistent structural unemployment, job insecurity from restructuring and
downsizing of many countries, and
 The deep poverty and widening international inequalities facing many of the poorest
developing countries of the world.

CHAPTER TWO
HISTORICAL DEVELOPMENT OF MODERN INTERNATIONAL TRADE THEORY
The three phases of the trade theories are, Pre classical, classical and modern schools
I. pre classical (Mercantilism represents the pre classical version)
II. classical theory (Adam Smith, David Ricardo and John Stuart Mill are associated with
the classical theory)
III. modern schools (The modern version is linked with two Swedish economists Eli
Heckscher and Bertil Ohlin)
2.1. Pre-Classical theory of International Trade (Mercantilism)

The economic philosophy that prevailed during the 17th & 18th Centuries was that of the
Mercantilism. Main feature of the mercantilist doctrine was a country could grow rich &
prosperous by acquiring more & more precious metals especially gold. Therefore, all efforts of
the state should be directed to such economic activities to acquire more & more precious metals.
If International Trade is not properly regulated, people might exchange gold for commodities
for daily use. This lead to the depletion of the stock of precious metals within the nation. Thus,
exports were viewed favorably so long as they brought in gold. Imports were looked with
hesitation as depriving the country‘s precious metals. Taxing imports was justified as a way of
creating jobs & income for the national population. Imports were supposed to be bad Because
they had to be paid for, which might cause the nation to lose spices (gold/silver). Imports were
also to be feared Because those same foreign goods might not be available in time of war.
2.2. The Classical Theory of International Trade

A. Smith (1723–1790) provided the basic building block for the construction of the classical
theory: Absolute Advantage model. Another well-known classiest, David Ricardo (1722 – 1823),
articulated & expanded it further: Comparative Advantage model. The models of Smith &
Ricardo together constitute as the SS version of the Classical Theory of Trade, Because both paid

almost exclusive attention to SS/production costs in the determination of TOT & gains from
trade. The Modern Version of the Classical Theory of Trade, however, treats SS & dd with equal
weight.
2.2.1 Adam Smith’s theory of Absolute Advantage

A. Smith challenged the mercantilist‘s views on what constituted the wealth of Nations, and
contributed to "nation building―/increasing the wealth & welfare of nations. Smith was the 1st
economist to show that goods, rather than gold, Good were the true measure of the wealth of a
nation than Gold.
Argument: the wealth of a nation would expand most rapidly if the Government would abandon
mercantilist controls over foreign trade. Smith exploded the mercantilist myth that IT is one
country gains at the cost of other countries. He showed how all countries would gain from
International Trade through international division of labor.
According to Smith, if one country has an absolute advantage over another in one line of
production and the other country has an absolute advantage over the first country in another
line of production then both countries would gain by trading. Let's discuss the Smiths model by
taking a simplistic world of 2 countries A & B both producing Rubber & Textile
Assumptions
1. Constant returns to scale in the production of both goods in 2 countries
2. Production possibilities are such that both countries can produce both goods if they wish.
3. Countries are endowed with X amounts of factors of production such that:
a) With X factors of production C(A) can produce either 100 units of rubber/50 units of
textile,/any other mix of rubber & textile, that satisfies the opportunity cost ratio of 2:1
b) With X factors of production C(B) can produce either 50 units of rubber/100 units of
textile,/ some other combinations of rubber & textile subject to the opportunity cost ratio of 1:2
It is quite clear that C(A) has absolute advantage in the production of rubber, C(B) has an
absolute advantage in the production of textile. Means that, there is symmetrical factor

distribution between 2 countries. There is scope for specialization in production & also a
scope for establishing mutually beneficial trade between 2 countries.
Autarky (Closed Economy) Situation

Table 1: Production & Consumption levels under Autarky Situation
Commodities Unit of output Opportunity cost ratio
Country Rubber Textile (GDP ) (R:T)
A 50 25 75 2:1
B 25 50 75 1:2
World 75 75 150
C(A) produces & consumes 50 units of rubber & 25 units of textile with a given production
technology & input SS and the total production, GDP, is 75 units & this is the maximum
consumption level. C(B) produces 25 units of rubber & 50 units of textile with a given
technology & input SS and also the total production of country B is 75 units & maximum
consumption will also be 75 units. For our simple world of 2 countries, world production &
consumption will be 150 units.
The case of Open Economy

Table 2: Production levels after International trade.
Commodities Unit of output
Country Rubber Textile (GDP )
A 100 0 100
B 0 100 100
World 100 100 200

Opening trade provides the 2 countries an opportunity to specialize in production and this in
turn leading to production & consumption gains. C(A) will specialize in the production & export
of rubber & C(B) will specialize in the production & export of textile. Both countries become
richer by 25 units than their situation without trade & this is due to production gain from
international trade. The world GNP has also increased from 150 to 200 units. Thus, C(A) has
specialized in the production of rubber …….& C(B) has specialized in the production of
textile.
What about consumption gains?

Both countries becoming richer & more specialized in terms of production. This depends on
how the gains from production are distributed between the 2 countries. means that.
Consumption gains in 2 countries depend up on the Terms of Trade (TOT). Is the matter of
how many units of rubber exchanged for one unit of textile between C(A) & (B).
Case 1. Trade at TOT = 1:1

At this TOT, C(A) agree with C(B) to exchange 1 unit of rubber for 1 unit of textile.
consumption gains determined by the taste pattern in the 2 countries & how much they want to
trade each other‗s goods. If C(A) & C(B) consume all they have produced, & have no taste for
the product of the other country, there will be no trade between countries, But if each country
wants to consume some mix of both goods; countries will trade each other‘s goods. C(A) could
export 40 units of rubber for 40 units of textile import from C(B) (at terms of trade 1:1).
After trade, C(A) has produced 100 units of rubber. Means that Consumers in C(A) want to
consume 60 of rubber, & can export 40 units of rubber to C(B) in exchange for 40 units
textile imports.
Table 3: Consumption shares after international trade at TOT=1:1

Commodities Total Consumption Consumption Gains
Country Rubber Textile

A 60 import 40 100 25
B import 40 60 100 25

World 100 100 200 50
Consumption level will increase by a total of 25 units in both countries than the case without
trade.
 If the TOT = the cost ratio of C(A), all the gains from trade will be attributed to C(B)
 If the TOT = the cost ratio of C(B), all the gains from trade will be attributed to C(A)
 Any other TOT between the cost ratio of the 2 countries may lead to unequal gains to
C(A) & C(B)
The country whose domestic cost ratio is smaller than the TOT; will gain the larger share &
vice versa. Means that. if TOT closer to the domestic opportunity cost ratio of C(A), and C(A)
will gain the smaller & C(B) will gain larger.
Case 2: Trade at TOT =Domestic opportunity cost ratio of country A = 2:1Table 4: Consumption shares
after trade at TOT =2:1
A 50 import 25 75 0
B import 50 75 125 50
World 100 100 200 50
All the consumption gains from IT go to C(B), Because the TOT is equal to the domestic
opportunity cost ratio of C(A) and Such a TOT is favorable to C(B), but does not bring any
change in welfare level of C(A).
Case 3: Trade at TOT =Domestic opportunity cost ratio of country B = 1:2Table 5: Consumption shares
after trade at TOT =1:2
Commodities Total Consumption
Consumption Gains
A 75 import 50 125 50
B import 25 50 75 0

World 100 100 200 50
All the consumption gains from IT go to C(A), Because the TOT is equal to the domestic
opportunity cost ratio of C(B). Thus such a TOT is favorable to C(A), but does not bring any
change in the consumption level of C(B).
Case 4: Trade at TOT = 2:3

Table 6: Consumption shares after trade at TOT = 2:3
A 60 import 60 120 45
B import 40 40 80 5
World 100 100 200 50
Most of the consumption gains from IT go to C(A), Because the TOT is closer to the domestic
opportunity cost ratio of C(B) than C(A). Such a TOT is more favorable to C(A) than C(B).
Case 5: Trade at TOT = 3:2

Table 7: Consumption shares after trade at TOT =3:2
Most of the consumption gains from IT go to C(B), Because the TOT is closer to the domestic
opportunity cost ratio of C(A) than C(B). Such a TOT is more favorable to C(B) than C(A). IT
would be beneficial & profitable for a country if it results in consumption gains.
A 40 import 40 80 5
B import 60 60 120 45
World 100 100 200 50

2.2.2 David Ricardo's Comparative Advantage Model

He argued that even if the countries did not have absolute advantage in any line of production
over the others, international trade would be beneficial; leading to gains from trade to all the
participating countries. Ricardo‘s model is termed as comparative advantage model.
Assumption of Ricardo’s Model

1. The world with 2 countries each producing 2 goods, rubber & textile
2. Both countries can produce both goods if they wish
3. Constant Returns to Scale in production of both goods in the 2 countries (Constant
Marginal Opportunity Cost condition)
4. One country‘s comparative advantage is grater in one line of production & the other
country‘s comparative disadvantage is smaller in the other line of production
The countries are endowed with X amount of factors of production such that:
a) With X factors of production C(A) can produce 120 units of rubber/120 units of textile/any
mix of rubber & textile conditioned by the opportunity cost ratio of 1:1 Producing a unit of
either commodity is the same in this country
b) With X factors of production C(B) can produce either 40 units of rubber/80 units of
textile/any mix of rubber & textile conditioned by the opportunity cost ratio of 1:2 Producing
rubber costs 2 times producing textile.
C(A) has an absolute advantage over C(B) in both lines of production, and C(B) has an
absolute disadvantage over C(A) in both lines of production. In terms of
relative/comparative advantage, C(A) has a greater comparative advantage in the production
of rubber as compared with the production of textile and C(B)'s comparative disadvantage is
smaller in the production of textile compared with the production of rubber. C(A) can produce 3
units of rubber whereas C(B) produces only 1 unit of rubber using the same unit of factor input.
C(A) can produce 1.5 units of textile whereas C(B) produces only 1 unit of textile unit of factor
input. Means that, One country's comparative advantage is greater in one line of production, &
other country‗s comparative disadvantage is smaller in other line of production. IT would

bring production & consumption gains for 2 countries.
Table 8: Production possibilities in county A & B
Commodities in units Opportunity cost ratio
Country Rubber Textile (R:T)
A 120 120 1:1

B 40 80 1:2
World 160 200
Let us see, the benefit from IT where one country has a larger comparative advantage in the
production of one good & the other country has a smaller comparative disadvantage in the
production of the other good.
Absolute advantage
o Country A has absolute advantage in the production of both textile & rubber over
country B
o Country B has absolute disadvantage in the production of both goods over country A
Relative (Comparative) Advantage

C(A)'s comparative advantage over C(B) is greater in the production of Rubber (3:1) as
compared to Textile (1.5:1) as well as C(B)'s comparative disadvantage over C(A) is lower in
the production of Textile (1:1.5) as against Rubber (1:3). C(B) can produce rubber at a higher
cost of production than textile. For C(B) the cost of producing 1 unit of rubber = cost of
producing 2 units of textile. Hence, C(A) would specialize in production of rubber & C(B) in
production of textile.
Theory of Comparative Advantage

A country should specialize in the production & export of those goods in which either its
comparative advantage is greater/its comparative disadvantage is smaller. It should import
those goods, its comparative advantage is smaller or its comparative disadvantage is greater.
Case 1 Autarky Situation

Table 9: Production and consumption under autarky
Commodities in units Total output or GDP
A 80 40 120
B 20 40 60
World 100 80 180
Thus C(A) produces & consumes 80 units of rubber & 40 units of textile with the given
production technology & input SS and The total production, GDP, is 120 units & this is the
maximum consumption. As well as C(B) produces 20 units of rubber & 40 units of textile
with its given technology & input SS. The total production of C(B) is 60 units & total
consumption will also be 60 units. World production & consumption: 180 units.
Table 10: Production levels after international trade
Commodities Total Consumption GNP gains

A 160 0 160 40
B 0 80 80 20
World 160 80 240 60
After trade, C(B) becomes richer by 20 units than the autarky situation & the world GNP
increases from 180 units to 240 units. C(A) has to specialize in the production of Rubber, for
which it has a greater comparative advantage and C(B) has specialized in the production of
textile, for which it has a smaller comparative disadvantage.

Distribution of consumption gains at different terms of tradeTable 11: Consumption levels after IT at TOT
= 3:4
Commodities Total Consumption Gains
Consumption

A 90 import 40 130 10
B import 30 40 70 10
World 120 80 200 20
The gains are equally distributed to C(A) & C(B) at TOT = 3:4
TOT is exactly half way between internal cost ratios of C(A) (1:1) & C(B) (1:2)
From table 10 & 11, although the production gains are obtained entirely by C(A), the
consumption gains are distributed equally between C(A) & C(B) is due to the equitable Terms
of Trade/TOT
Table 12: Consumption levels after IT at TOT =1:1

A 80 import 40 120 0
B import 40 40 80 20
World 120 80 200 20
All the gains in consumption are appropriated by C (B), Because TOT is equal to the internal
opportunity cost ratio of C (A) due to this C(A) will not gain anything from IT. Means that the
cost of importing the good is the same as the cost of producing that good domestically.

Table 13: Consumption levels after IT at TOT = 1:2

A 90 import 60 150 20
B import 30 20 50 0
World 120 80 200 20
All the gains in consumption are appropriated by C(A), Because TOT is equal to the internal
opportunity cost ratio of C(B)
2.2.3 Law of Reciprocal Demand Offer curve Analysis

Reciprocal DD was developed by J.S. Mill (1848) when he wrote book: Principles of Political
Economy. Later Offer curve technique was developed by Edgeworth & Marshall
Offer curve shows how the TOT determined by the interaction of DD & SS.
Assumptions
The world with 2 countries A & B, specializes in textile & rubber respectively
Law of reciprocal DD, ―TOT determined by A‘s DD for B‘s product & B‘s DD for A‘s
product‖ means that, the TOT determined by the intensity of domestic DD for foreign goods
or offer curve of the C(A) & C(B).
The equilibrium TOT is determined at the point where the offer curves of the 2 countries
intersect.

Table 14: Schedule of Trade Propensity for country A
Textile (Exportable) Rubber (Importable) Potential Terms of Trade ratios
25 5 5:1
40 10 4:1
60 20 3:1
80 40 2:1
100 100 1:1
90 120 0.75:1
Table 14 indicates, textile is exportable product, & rubber is importable product in C(A).
C(A) has completely specialized in the production of textile, Because it has an absolute/
comparative advantage. If consumers in C(A) want to consume rubber, …..fulfilled only by
importing it from C(B).
Initially C(A) does not have any rubber to consume, it is willing to export 25 units of textile
in exchange for 5 units of rubber at TOT 5:1. This is the highest TOT & as trade continues
between A & B, the TOT declines.
Initially the marginal utility of rubber for C(A) is so high, But as trade continues & C(A)
consumes more & more of the imported product (rubber), the marginal utility from additional
consumption of rubber goes down and decrease in the TOT ratios from 5:1 to 1:1.
Law of diminishing marginal utility where the consumer is willing to pay higher price per unit
of utility initially, but only lower price for subsequent unit that buys. We can plot the
information in table 14 & draw the offer curve of C(A) as shown below


The continuous line from the origin connecting all points, 1,2,3,4, & 5 is the offer curve of
country C(A) ,OA. A positive slope & non-linear and Its positive slope derives from C(A)‗s
desire to trade more at different TOT. Up to point 5, its slope continues to be positive. At point 5,
C(A) is willing to offer 100 units of textiles in exchange for 100 units of rubber and Beyond
point 5, its slope to be negative. At point 5, C(A) exports 100 units, its desire/the capacity to
export more textiles is exhausted. At point 6, C(A) is willing to accept/import 120 units of rubber
at a price of only 90 units of textile exports and will not be acceptable to C(B) and for C(B) it is
better to sell 100 units of rubber & buy 100 units of textiles at point 5 than trading at point 6.
Means that, C(A) would be willing to trade with C(B) even beyond point 5, but this will not be
acceptable by C(B). Therefore, trade virtually cannot take place beyond point 5.
Properties of offer curve

The relevant portion of the offer curve is positively sloped. Only the positively
sloping portion of the offer curve is relevant for trade equilibrium. The negative
portion of the other offer curve is an irrelevant range
The offer curve is not a straight line, it is a non-linear curve. This is due to the law of
diminishing marginal utility
The offer curve is a composite curve (both DD & SS). Each point on the offer curve
represents the demand of the country for imports & supply of the country(exports).
The offer curve is similar with the potential TOT.
3. THE MODERN THEORY OF INTERNATIONAL TRADE
The 2 main propositions of the modern theory of international trade are the Factor-Endowment
theory (Heckscher-Ohlin theorem) & the Factor-Price equalization theorem. The Factor-
Endowment theory (H-O Theorem): a country has a comparative advantage in the
production & exports of that commodity which uses more intensively the country's relatively
abundant factor of production. The Factor-Price Equalization Theorem: the effect of trade is
to equalize factor prices b/n countries, thus serving as substitute for international factor
mobility.

3.1 The H-O Theorem (Factor-Endowment theory)

Theory of international trade heavily relied on the factor proportions analysis developed by
the 2 Swedish economists, Eli Heckscher (1919) & Bertil Ohlin (1933). According to their
theory, the immediate cause of international trade is, the difference in the relative prices of
commodities b/n the countries. Differences in the commodity prices arise on account of the
differences in the factor supplies (endowments) in 2 countries.
Assumptions:
Only 2 factors of production-labor & capital.
Only 2 countries & they are different in factor abundance, ( e.g. one country is
capital abundant but labor scarce and the other country is labor abundant but capital
scarce).
Only 2 commodities. The production functions are the same for each good in the 2
countries.
On the basis of these assumptions: The H-O theorem predicted, the capital surplus country
specializes in the production & exports of capital intensive goods, & the labor surplus country
specializes in the production & exports of labor intensive goods. Well-known structure of trade
prediction of the H-O model.
Define the term Factor Abundance

3.1.1 Factor Abundance
There are 2 criteria for defining the term factor abundance. These are price criterion & physical
criterion.
The Price Criterion
A country in which capital is relatively cheap & labor is relatively more expensive, is regarded
as the capital abundant country, regardless of the physical quantities of capital & labor available
in this country compared with other country. A labor abundant country would be defined as
one where labor is relatively cheaper & capital is more expensive.
The Physical Criterion

Physical criterion: a country is relatively capital abundant if it is endowed with a higher

proportion of capital to labor than the other country. Means that, if the capital to labor ratio
of C(A) is larger than the capital to labor ratio of C(B) as well as C(A) is a capital surplus
country & C(B) is a labor surplus country. This criterion takes into account only the SS of
factors/ physical terms as a base for defining factor abundance. It does not take factor dd into
account.
H-O proposition under factor abundance

3.1.1.1 Price Criterion of Factor Abundance & the Structure of trade
The set of factor price ratios (iso cost curves) in C(A), capital surplus, shown by the parallel iso
cost lines P0P0 & P0'P0'. The slope of the iso cost curve shows the factor price ratios in C(A)
and .Slope of Iso cost curve ΔK/ ΔL= PL/PK. The relative steepness of these lines reflects
capital is cheaper & labor is dearer in C(A) .
P1P1 & P1'P1' also reflect the factor price ratios (isocost curves) in C(B). The relative
flatness of these lines shows labor is cheap & capital is expensive in C(B), labor surplus
country. The two isoquants labeled aa & bb, & cut each other only once, i.e. at point Q. This
indicates that there is no reversal of factor intensity. Means that, one commodity is capital
intensive in both countries & other commodity is labor intensive in both countries.
Cost of Production in C(A)

The cost of producing one unit of K good is made up of HD amount of capital plus HF amount
of labor, at point H there is a tangency b/n the isocost curve P0P0 & the isoquant for K good.
The cost of producing one unit of L good consists of OF=JE amount of capital (w/c is equal to a
unit of capital required to produce the K-good) but more amount of labor OE Means that, in
C(A), to produce one unit of L good, it needs to use the same amount of capital as in K good
(HD=JE = OF) but more labor (OE as against OD). The isoquant curve of K-good is tangent at
the lower isocost curve of C(A) and the isoquant curve of L-good is tangent at the upper isocost
curve of C(A). This is the implication producing K-good is cheaper than producing L-good in
C(A).
Hence, capital surplus country, C(A), would specialize in the production & exports of capital-
intensive good.
OF/ OD (k –good) > OF/ OE (L–good) for C(A)
ON/ OG (k –good) > OT/ OG (L–good) for C(B)
Cost of Production in C(B)
The cost of producing one unit of L good is made up of OT = MG amount of capital plus OG
amount of labor, but the cost of producing one unit of K good consists of the same amount of
labor but more amount of capital i.e. ON = RG.
Hence, C(B) can produce L good at a relatively lower cost of production per unit. C(B) (a labor
surplus country) would specialize in the production & exports of L good (labor intensive good).
Physical criterion of factor abundance & the structure of trade
C(A) is capital abundant & C(B) is labor abundant if the capital to labor ratio of C(A) is
greater than the capital to labor ratio of C(B).
KA/LA >KB/LB
Where KA & LA are the total amounts of capital & labor, respectively, in C(A),
KB & LB are the total amounts of capital & labor, respectively, in C(B).
C(A), a capital abundant country by the physical criterion, has a bias in favor of producing
capital-intensive good and C(B), a labor abundant country will have a production bias in favor
of labor-intensive good production.
Fig. 3.2 reflects the nature of these biases in 2 countries in respect of the 2 goods.
The PPC of C(A) is AB & that of C(B) is CD.
Assume, Steel is capital intensive good

Cloth is labor intensive good.
Suppose 2 countries produce in the same proportion along the ray OB and C(A) would produce
at Q1 & C(B) at Q2. NB. The slope of C(A)'s PPF at Ql is steeper than the corresponding
slope of C(B) at Q2. Similarly, the commodity price line PlP1 is steeper than the line P2P2.
Steel production is cheaper in C(A). cloth production is cheaper in C(B) C(A) has a bias in
producing more steel. C(B) has a bias in producing more cloth
Would C(A) export steel & C(B) export cloth?
It depends on the dd (consumption) factors in each country. This gives rise to 2 possibilities:
a. If consumption bias & the production bias are towards the same direction, then
C(A) would import rather than export steel & C(B) would import rather than
export cloth. In this case the H-O prediction would then be invalid
b. If consumption & production biases are in the opposite direction, then the H-O
prediction will be valid, viz. C(A) would export steel & C(B) would export cloth.
Critical evaluation of the H-O theorem

The H-O theorem has been criticized mainly along 3 lines of arguments.
Factor intensity reversal argument
The H-O theorem was based on the assumption of no factor intensity reversal. i.e, the
production functions are different for different goods but identical for each good in 2
countries. One good is capital intensive & the other good is labor-intensive; but the same good,

which is capital-intensive in one country, must be capital intensive in other country. The same is
also, labor intensive good remains labor intensive in both countries. This assumption is only
guaranteed when the 2 isoquants of the capital-intensive & the labor intensive goods-cut each
other only once but not more than once. If factor intensity reversal takes place, then the 2
isoquants would cut each other more than once: H-O theorem would be invalid. Lines P0 &
P’0, the factor price ratios in C(A) (capital surplus country) and Lines P1 & P’1, the factor
price ratios in C(B) (labor surplus country).
The 2 production isoquants for steel & cloth cut each other twice once at pt A & the second
time at point B.
In fig. 3.5, note the ff factors:
In C(A), steel is labor-intensive & cloth is capital intensive.
To produce one unit of steel/cloth, C(A) has to use the same amount of capital but more
labor for steel than for cloth. Capital rich , C(A), would specialize in the production &
exports of capital intensive good, cloth. It would import steel which is a labor intensive
good.
In C(B), cloth is labor-intensive & steel is capital intensive.
To produce one unit of cloth, it takes a given amount of labor & smaller amount of capital
as compared to steel. Steel takes same amount of labor but more capital. Labor rich C(B),
would specialize in the production & exports of the labor-intensive good, cloth. It would
import steel which is a capital intensive good. In a factor intensity reversal, both countries
produce & export the same commodity. In the capital rich country, C(A), cloth is a capital-
intensive product. In the labor rich country, C(B), cloth is a labor-intensive product. Steel is
a labor intensive product in the capital rich country, C(A). Steel is a capital-intensive

product in the labor rich country, C(B). This is a situation of factor intensity reversal. This
would invalidate the H-O prediction
Leontief paradox
First comprehensive & detailed examination of the H-O. As the theory of factor
proportions predicted, capital abundant country exported capital-intensive goods &
imported labor-intensive goods. USA, capital rich & labor scarce country, would expect
to export capital-intensive goods & import labor-intensive goods. Leontief made an
extensive study of the US structure of trade & the results were surprising. Contrary to
the H-O theory, US exports consisted of labor-intensive goods & imports consisted of
capital-intensive goods. In Leontief‘s own words, "America's participation in division of
labor in intern’l trade is based on its specialization in labor intensive rather than
capital-intensive lines of production. i.e. The country resorts to foreign trade in order to
economize its capital & dispose of its surplus labor.
Leontief’s findings are summarized in the following table:
Exports Imports Replacements

Capital (US $ in 1947 prices) 2550780 3091339
Labor (man years) 180313 170004
Capital Labor ratio (US $ per man 13911 18185
hour)
Demand reversal argument

The production & consumption biases operate in the same direction in each country. A capital
surplus country will go for specializing in the production of capital intensive good but it will
export a labor intensive good & a labor surplus country will go for exporting capital intensive
good. This structure of trade is contrary to the H-O prediction. Therefore, if dd reversal takes
place in both countries, the H-O prediction about the structure of trade will be invalid.
The Factor Price equalization theorem
States that the effect of trade is to equalize factor prices b/n countries, thus serving as substitute
for intern’l factor mobility. A nation with trade finds output expanding in its comparative
advantage industries, which uses a lot of cheap & abundant factor. As a result of the rise in dd

for the abundant factor, its price increases. At the same time, scarce, expensive factor is being
realized from the comparative disadvantage industries & its price falls along with its dd and
.each nation experiences a rise in the price of abundant factor & a fall in the price of the scarce
factor.
Prior to specialization we have the ff situations:

China is a labor abundant country & price of labor is lower.
Canada is a labor scarce country & price of labor is high.
China has a comparative advantage in labor intensive good, cloth, while Canada reduces the
production of cloth. When China continues to specialize in cloth, the dd for labor tends to rise
& the price of labor gets higher & higher. As Canada reduces the production of cloth, the dd
for labor decreases & labor becomes cheaper. Trade tends to equalize the price of labor in 2
nations.
Assumptions
I. A model of 2 countries C(A) & C(B), produce X & Y
II. 2 factors of production ( K & L)
III. Before trade (i.e. in a situation of autarky) :
In C (A), labor surplus country, labor is abundant & cheap, & capital is scarce & expensive.
Once the trade is opened up, labor becomes scarce & price of labor will go up, & capital
becoming abundant & cost of capital going down. In C(B), capital surplus country, capital is
abundant & cheap, & labor is scarce & expensive. Once the trade is opened up, capital
becomes scarce & price of capital will go up, & labor becoming abundant & cost of labor
going down Contract curve is a line that joins the locus of pts at w/c the isoquant curves of 2
commodities are tangent to each other.

Contract curve is a line that joins the locus of points at w/c the isoquant curves of 2
commodities are tangent to each other. At the tangency points, the slopes of the 2 contract
curves are equal representing that the marginal rate of technical substitution of labor for capital
for the 2 goods are equal.

CHAPTER THREE
INTERNATIONAL TRADE POLICY
3.1. The Instruments of Trade Policy
Trade policy uses seven main instruments: tariffs, subsidies, import quotas, voluntary export
restraints, local content requirements, administrative policies and antidumping duties.
1. A tariff is a tax levied on imports or exports. They are divided in two categories:
 Specific tariffs: are levied as a fixed charge for each unit of a good imported.
 Ad valorem tariffs: are levied as a proportion of the value of the imported good.
In most cases, tariffs are placed on imports to protect domestic producers; tariffs
increases government revenues.
2. A subsidy is a government payment to a domestic producer. They take many forms like, cash
grants, low-interest loans, tax breaks and government equity participation in domestic firms.
Subsidies help domestic producers in two ways: (1) competing against foreign imports and
(2) gaining export markets.
3. An import quota is a direct restriction on the quantity of some good that maybe imported
into a country. The restriction is usually enforced by issuing import licenses to a group of
individuals or firms.
4. A voluntary export restraint is a quota on trade imposed by the exporting country, typically
at the request of the importing country‘s government.
5. A local content requirement is a requirement that some specific fraction of a good needs to
be produced domestically.
6. Administrative trade policies are bureaucratic rules designed to make it difficult for imports
to enter a country.
7. Antidumping duties. Dumping is a variously defined as selling goods in a foreign market at
below their costs of producing; dumping is viewed as a method by which firms unload excess
production in foreign markets. Antidumping policies are designed to punish foreign firms
that engage in dumping. Their objective is to protect domestic producers from unfair foreign
competition.

3.2. Arguments in Favour of and Against Trade Protection

3.2.1. Free trade: Case for and against
A policy of no restrictions on the movement of goods between countries is known as the policy of
Free Trade. Restrictions placed with a view to safeguarding home industries constitute the policy
of protection. In the words of Adam Smith, the term 'free trade' has been used to denote "that
system of commercial policy which draws no distinction between domestic and foreign
commodities and, therefore, neither imposes additional burdens on the latter, nor grants any
special favours to the former." Free trade, however, does not require the removal of all duties on
commodities. It only insists that they shall be imposed exclusively for revenue and not at all for
protection.
Adam Smith wrote: "If a foreign country can supply us with a commodity cheaper than we
ourselves can produce, better buy it from them with some part of the produce of our own
industry, employed in a way in which we have some advantage." He continued further: "Whether
the advantage which one country has over another be natural or acquired is in this respect of no
consequence. As long as one country has those advantages and the other wants them, it will
always be more advantageous for the latter rather to buy of the former than to make." The only
exception that Adam Smith would make was industries necessary for defense. These might be
protected since defense is more important than opulence, he said.
The doctrine of free trade is the extension of the doctrine of division of labor to the international
field. In the words of Adam Smith again, "Individuals find it for their interest to employ their
industry in a way in which they have some advantage over their neighbours." And he adds,
"What is prudence in the conduct of every private family can scarce be folly in that of great
kingdom." In short, the free trade theory is that such a policy enables every country to devote
itself to those forms of production for which it is best suited on the basis of comparative
advantages.
3.2.2. Cases For free trade
The term 'protection' is used to denote a policy of encouraging the home industries by the use of
counties or by the imposition of high customs duties on foreign products. The objective is to
build up great national industries even by sacrificing utilities on the part of existing consumers.
The arguments for protection are stated below.
Infant Industry Argument

This argument was put forward by Friedrich List, J. S. Mill, Alfred Marshal and Souderton. In
the words of Mill, "The superiority of one country over another in a branch of production often
arises only from having started it sooner. There may be no inherent advantage on one part or
disadvantage on the other, but only a present- superiority of acquired skill and experience. Thus,
J. S. 'Mill, one of the advocates of free trade, accepted only one argument. In Mill‘s words it ran
thus: ―A productive duty, continued for a reasonable time, might sometimes be the least
inconvenient mode in which a nation can tax itself for the support of such an experiment
(introducing new industries). But it is essential that protection should be confined to cases in
which there is good ground of assurance that the industry which it fosters will after a time be
able to dispense with it. Alfred Marshall, to produce social benefit goods, an infant industry
must first grow up. It must eventually be able to compete at world market prices. This argument
specially applies to countries that enter the industrial field at a later stage. Such countries possess
potential advantages which may not become effective unless- foreign competition is excluded for
a period of time. Unless an industry in its infancy is protected till it acquires strength and
maturity, it will die in the face of foreign competition.
The infant industry argument rests on the following grounds:
 Every country has its own potentialities for developing some industries in the form of labour
skill, raw materials and entrepreneurial talent. No country is completely devoid of productive
elements which may yet be latent.
 Every nation has the right to develop its potentialities or discover its latent productive
powers. No nation would like its efforts for economic development to be smothered before it
has had a full chance for trial and error.
 It takes time for the productive elements to be developed. Labour can be trained; raw
materials can be improved; and entrepreneurs can become competent by experience. But they
should have enough time to develop and discover themselves.
 Infant industries cannot be expected to withstand completion from old and well- entrenched
industries. It will be unfair to expose new industries.
 If infant industries are not duly protected against competition from strong and well-
established' industries, they are bound to die. This will mean waste of valuable national

assets invested in the industry and a serious setback to entrepreneurial venture in future.
In spite of these weaknesses, the argument has been widely accepted and many countries have
industrialized themselves through protection given on the basis of this argument, e.g., the U.S.A.
and several members of the British Commonwealth, including India. But it is recognized that
protection should not be given on a permanent basis. It should be given for a definite period
considered sufficient for the industry to grow. Moreover, it should not be given indiscriminately
to all industries. The industries to be given protection should be selected with proper care and
discrimination so that scarce productive resources of the community are properly allocated.
Diversification of Industry Argument

According to List, a nation should have a variety of sources of production and employment.
Depending on one industry or on a few industries is dangerous both politically and economically.
Politically it means too much dependence on foreign trade which may be cut off during a war.
Economically, a country depending on a few industries is exposed to the danger of serious
economic dislocation in case some adverse circumstances affect such an industry. According to
this argument a country must produce even those articles in which it may not have comparative
advantage.
Employment Argument
It is argued that industrial development through protection increases employment in a country.
Conversely, if protection is not given to old established industries; foreign competition may
ruin them and create unemployment in the country.
Conservation of National Resources Argument

If a country exports its exhaustible materials in a raw-state, it loses manufacturer's profits. It
may also be seriously handicapped when such materials have been altogether exhausted
because of free trade.
Defense Argument
Adam Smith remarked "Defense is better than opulence". It is said that essential to make a
country militarily strong though it may not be economically prosperous. Hitler preached to the
German nation, "Gun! Better than butter." According to this argument a country must actively
encourage the development of those industries which are essential from the point of view of
defense, even though it may result uneconomic distribution of the national resource. The
advocates of free trade point out that this is politics and not economics. On purely economic
grounds, they say, free trade is the best.
Revenue Argument
Protection is also advocated for revenue purposes. When protective import duties are imposed,
they certainly bring in revenue to the government. But it may be pointed out that there is a
certain degree of incompatibility between the revenue and protection. If full protection is given,
the government will not get any revenue, because full protection will mean that domestic goods
have driven foreign goods altogether. When foreign goods not come in, there will be no
revenue from import duty. On the other hand, if government wants revenue then foreign goods
must come in and compete with domestic goods. Then domestic industries do not get any
protection. This incompatibility, however, arises between maximum protection and maximum
revenue. But if the duties are moderate, they will yield revenue besides affording protection. It
is, however, much better to advocate protection for the sake of protecting industries rather than
for raising revenues.
Key Industry Argument

If the industrial structure of a country is to be stable and sound, the country must develop 'key'
or basic industries; otherwise foundation of industries will have been laid on sand. The country
may not have any comparative advantage in such industries. But since they are of crucial
importance and have to be developed, protection must be granted to them.
Balance of Payments Argument

It may become necessary to check imports by means of tariff in order to rectify adverse balance
of payments. Import restrictions on non -essential imports become necessary in the interest of
accelerated economic growth.
Self-sufficiency Argument
Another argument in favour of protection is that we should become self-sufficient and not
depend on other countries for our necessaries. Such dependence proves very dangerous during
war when foreign trade is cut off.
Avoid unfair competition

Protection also becomes necessary against unfair competition from abroad arising from dumping,
depreciated exchanges, abundances, etc.
For Economic Stability

Protection is also advocated to shut out the baneful influences trade cycles from abroad. It is
expected to make the domestic economy immune from the destabilizing effects of external
disturbing factors.
Trade Policy and Economic Welfare
Trade policy refers to the regulations and agreements that control imports and exports to foreign
countries. Learn more about trade agreements including NAFTA, CAFTA, and the Middle
Eastern Trade Initiative, as well as regulations, farm subsidies, and tariffs. Trade Policy and
Economic Welfare expounds the normative theory of trade policy. International trade tends to
reduce the prices of consumption goods, creating welfare gains for consumers in importing
countries. Welfare gains through reduced costs of consumption may be larger than gains or
losses through income changes.
The welfare effects of trade policy under imperfect competition are decomposed into four
possible channels: (1) a deadweight loss from distorting consumption and production decisions;
(2) a possible gain from improving the terms of trade; (3) a gain or loss because of changes in the
scale of firms; and, (4) a gain or loss from shifting profits among countries. In many industries,
quotas have led to an increase in the quality of imports purchased, which is an optimal response
by consumers and firms. Trade liberalization benefits better performing firms and contributes to
economic growth. There is evidence that better performing firms tend to enter international

markets. Internationally active firms are larger, more productive, and pay higher wages than
other firms in the same industry. Which trade promotes economic welfare?
In general, trade has a positive and significant impact on economic growth, which is consistent
with the evidence in the empirical literature. A one percents rise in the average trade to GDP
ratio leads to an increase in the average GDP per capita growth by about one-half (0.47)
percentage point.
Trade is critical to America's prosperity - fuelling economic growth, supporting good jobs at
home, raising living standards and helping Americans provide for their families with affordable
goods and services. U.S. goods trade totalled $3.9 trillion and U.S. services trade totalled $1.3
trillion.
How does trade increase welfare?
International trade tends to reduce the prices of consumption goods, creating welfare gains for
consumers in importing countries. Welfare gains through reduced costs of consumption may be
larger than gains or losses through income changes.
How does trade influence economic development within a country? International trade and
investment is critical to the Australian economy, providing jobs and prosperity. International
trade and investment opens up opportunities for Australians to expand their businesses. This
benefits Australian consumers through access to an increased range of better-value goods and
services.
Does trade improve welfare? Trade promotes economic growth, efficiency, technological
progress, and what ultimately matters the most, consumer welfare. By lowering prices and
increasing product variety available to consumers, trade especially benefits middle- and lower-
income households.
Does trade promote growth or does growth promote trade? Trade enhances the efficient
production of goods and services through allocation of resources to countries that have
comparative advantage in their production. Foreign trade has been identified as an instrument
and driver of economic growth (Frankel and Romer, 1999).

How does trade work in the global economy? Global trade allows wealthy countries to use their
resources for example, labor, technology, or capital more efficiently Therefore, they may sell
it more cheaply than other countries. If a country cannot efficiently produce an item, it can obtain
it by trading with another country that can.
How do government policies affect international trade? Governments have three primary means
to restrict trade: quota systems; tariffs; and subsidies. A quota system imposes restrictions on the
specific number of goods imported into a country. ... Subsidies are grants given to domestic
industries to help them develop and compete with foreign producers.
How might trade agreements benefit consumers? A central tenet of international economics is
that lowering trade barriers increases welfare. Trade agreements between countries lower trade
barriers on imported goods and, according to theory, they should provide welfare gains to
consumers from increases in variety, access to better quality products and lower prices.
3.3. Optimal Trade Policy Intervention
What is optimal Policy? Pareto-optimal, the optimal non-cooperative trade policy consists of a
positive import subsidy. (Export tax) that improves domestic terms of trade, instead of a tariff
(subsidy).
3.4. The Process of Trade Liberalization
Trade liberalization is the removal or reduction of restrictions or barriers on the free exchange of
goods between nations. These barriers include tariffs, such as duties and surcharges, and
nontariff barriers, such as licensing rules and quotas. Liberalisation is the process or means of the
elimination of control of the state over economic activities. It provides a greater autonomy to the
business enterprises in decision-making and eliminates government interference.
3.5. The Political Economy of Protection
The Political Economy of Protection explains why countries, especially developing

countries, change their trade policies over the course of history. It does so through an
interdisciplinary approach, which borrows analyses from both political science and economics.

Protectionism, policy of protecting domestic industries against foreign competition by means of

tariffs, subsidies, import quotas, or other restrictions or handicaps placed on the imports of
foreign competitors. In other words it is the economic policy of restricting imports from other
countries through methods such as tariffs on imported goods, import quotas, and a variety of
other government regulations.
There are various methods of trade protectionism whose goal is to protect a nation's economic
well-being. These include: Tariffs which are a tax on imports from other countries and foreign
markets. There is also voluntary export restraint (VER) that acts as a trade quota imposed by
an exporting nation.
3.5.1. Arguments Against protection
1. Vested interests are created
Once certain industries are given protection, they claim it as a matter of right. It then becomes
very difficult to take away protection. The infants begin kicking if you touch them in any
manner. Such infants refuse to admit that they have grown into adults.
Protection produces laziness and acts like an opiate
When foreign competition has been removed, it sends the home manufacturers to sleep, as it
were. They do not try to make any improvement, and technical progress comes to a standstill.
Protection creates monopolies
Tariff is said to be the mother of trusts. When foreign competition has been removed, the home
manufacturers are tempted to combine to reap monopoly profits.
Consumers and unprotected industries suffer
This is so because imposition of import duties invariably leads to the rising of prices.
The distribution of wealth becomes more unequal
Protection favour the rich capitalists who grow still richer. The gulf between the 'haves' and
'have-nots' is thus widened still further.
Source of conflict
Protection leads to conflict, friction and retaliation in international dealings. It thus breeds
the germs of future wars.
Inefficiency in world resource allocation
The most important argument against protection on economic grounds is that it militates against
optimum utilization of resources. It hampers international division of labor so that labor, capital

and other factors of production do not find their most remunerative employment. Their distri-
bution is not governed by natural economic forces, but they are artificially forced into certain
channels. The result is that they do not make their maximum possible contribution in the
production of commodities. The world output is lower than it could be, so that the standard of
living is necessarily lowered. A natural movement towards world prosperity is hindered.
Tariffs and Non - Tariff Barriers to Trade
The two broader categories of barrier to free trade between countries are natural barriers and
man-made barriers. Natural barriers to trade: arise on account of the cost and the distance
involved in moving goods and services from one country to another. In short, it is the transport
cost. Man-made barriers is further classified into tariff and non-tariff (hidden) barriers.
3.5.2. Tariff and Its Effects
What is tariff?
Imposing tariffs is the oldest and simplest way for governments to intervene in the market—and
tariffs are the easiest type of trade barrier for the WTO to limit. A tariff is just a tax levied on
imports that effectively raises the cost of imported products relative to domestic products. .
Types of Tariffs
1. Specific tariffs: are tariffs which are assessed on the basis of the physical weight of the
product which is imported or exported. The units are in terms of Birr/Kg, Birr/ tone. They
can be levied on goods like wheat, sugar, coffee, cattle, etc. Specific tariffs cannot be levied
on valuable goods like diamond, modern art paintings, TV etc.
2. Ad valorem tariffs: are tariffs levied based on the value of the product. It is a percentage
tax. Ad valorem tariff is revenue elastic but specific tariff is not.
3. Compound tariff: combines a specific duty with an ad valorem duty.
4. Discriminatory tariff calls for different rates of duties depending on the country of origin
or destination of the product
5. Non-discriminatory tariffs: uniform tariffs rates imposed on goods and services regardless
of their source of origin or destination. Tariffs are said to be single column when they are
non- discriminatory and double-column when they are discriminatory.
6. Revenue tariffs: these are tariffs that are imposed primarily and produce revenue for the
government

7. Protective tariffs: are tariffs that are imposed primarily to protect the domestic industries
from foreign competitions
8. Tit-for-tat tariffs: when country A imposes (increases) duties against the products from
country B, it is possible that country B will retaliate and levy duties on goods imported from
country A. Thus, country B‘s tariffs are then described as retaliatory tariffs.
9. Countervailing tariffs: Tariffs are said to be countervailing when a country imposes
(increases) import duties with a view to offset export subsiding in the country of origin.
3.5.2.1. Effects of import tariff on tariff imposing country
Tariff is an important tool of commercial policy. Although it is primarily a protectionist device

yet it proves to be a double-edged weapon. On the one hand, it limits consumers‘ choice by
forcing them to cut consumption of the goods they like and, on the other; it shifts the use of
resources from one use to another. The effect of tariffs is to change relative prices of goods,
services and factors of production.
3.5.3. Non-tariff barriers
Non-tariff barriers encompass a variety of measures. Some have insignificant trade
consequences; for example, labelling and packaging requirements can restrict trade, but
generally only marginally. Other non-tariff barriers significantly affect trade patterns; examples
include import quotas, voluntary export restraints, subsidies and domestic content requirements.
These non-tariff barriers are intended to reduce imports and benefit domestic producers. There
are several reasons suggested for why countries use non-tariff barriers instead of tariff.
Political reason
Politicians may sometimes be reluctant to levy a tariff because it is an explicit tax on domestic
consumers. Although non-tariff barriers result similar consumers‘ welfare loss like tariff, the
non-tariff barriers‘ effect tends to be more remote and less visible. Politicians may therefore
perceive non-tariff barriers as being more acceptable to the voting public.
Certainty of restrictive impact of non-tariff barriers
The restrictive impact of non-tariff barriers is relatively more certain as a protection instrument
than tariff. For example it may be much easier to show that a quota of 5 million tons restricts

food imports to 5 million tons than to show conclusively that a tariff of Birr 20 per ton would
result in imports of only 5 million tons of food imports.
Moreover, a rise in an import tariff may encourage the exporting country to subsidize its
exporting companies to make them more price-competitive, thus offsetting the tariff‘s restrictive
impact. Such subsidies, however, would not alter the restrictive impact of an import quota or
other non-tariff barriers.
Non-tariff barriers are not covered by rule of WTO (former GATT)
Many nations have adopted non-tariff barriers because they are not covered by the main body of
rules of conduct in international trade, the General Agreement on Tariffs and Trade (GATT).
Although GATT has succeeded in liberalizing tariffs in post-WWII era, nations have
circumvented GATT rules by using loopholes in agreements & levying types of non-tariff
barriers over which trade negotiations have failed.
3.5.3.1. Import quota
A Quota is a direct limitation of the physical quantity of exports and imports permitted in the
country. We will only discuss import quotas as they are more common than the export quotas.
An import quota is a physical restriction on the quantity of goods that may be imported during a
specific time period; the quota generally limits imports to a level below that which would occur
under free-trade conditions. The effects of quotas are similar to those of tariffs, but there are also
substantive differences between the two which are worth examining.
Types of Quotas
1. Unilateral quotas
Unilateral quotas can be global and has price advantage, or allocated. Import quotas are
generally imposed unilaterally by the home government, without prior negotiation or
consultation with other nations. They are levied and administered exclusively by the importing
nation. Because of their unilateral nature, import quotas may be resented by other nations and
may lead to retaliatory quotas.
Global quota
One way of administering import limitations is through a global quota. This technique permits a
specified number of goods to be imported each year, but does not specify where the product is
shipped from or who is permitted to import. When the specified amount has been imported (the
quota is filled), additional imports of the product are prevented for the remainder of the year. In
practice, the global quota becomes unwieldy because of the rush of both domestic importers and
foreign exporters to get their goods shipped into the country before the quota is filled. Those who
import early in the year get their goods; those who import late in the year may not. Moreover,
goods shipped from distant locations tend to be discriminated against because of the longer
transportation time. Smaller merchants, without good trade connections, may also be
disadvantaged relative to large merchants. Global quotas are thus plagued by accusations of
favouritism against merchants fortunate enough to be the first to capture a large portion of the
business. For these reasons, global quotas are relatively uncommon, especially among industrial
nations.
Selective ( allocated) quota
To avoid the problems of a global quota system, import quotas are usually allocated to specific
countries; this type of quota is known as a selective quota. For example, the
Ethiopia might impose a global quota of 10 million tons of canned food per year, of which 3
million must come from the Kenya, 4 million from Germany, and 3 million from Saudi Arabia.
Customs officials in the importing nation monitor the quantity of a particular good that enters the
country from each source; once the quota for that source has been filled, no more goods are
permitted to be imported.
2. Bilateral quotas
Bilateral quotas imply mutual agreement between countries through negotiations. They do not
provoke retaliation.
Mixing or indirect quotas
In this case the domestic producers are asked to use a fixed proportion of imported and domestic
materials in producing their products. The quota is fixed not in absolute forms but in percentage
forms.
3.5.3.2. Tariffs versus quotas
The effects of quotas are similar to those of tariffs, but there are also substantive differences
between the two which are worth examining.
Similarities
1. they both have the same objectives like protecting domestic industries, correcting BOP, and
expand domestic employment and economic activities

2. A tariff of a certain height cuts imports to a certain quantity. It has, therefore a quota
equivalent effect. At the same time a quota would limit imports to a certain quantity and
therefore, raises the import price. A quota has, thus, a tariff equivalent effect.
3. Since both quota and tariffs raise the import price and reduce the import quantity they
produce similar effects on consumption, production, trade balance, TOT, national income
redistribution, factor movements, economic growth and economic welfare.
Differences
1. Tariffs bring revenue to the government whereas quotas do not. Under tariff same of
consumers‘ loss goes to government in the form of revenue. But under quota it is
ambiguous. It could go to government if it charges a fee for selling import licenses and if
not, some of consumers loss will be distribute to importers and the imports welfare will
increase further more. Tariff revenues can be used for investment on social services, but the
quota profits going to importers may not contribute to net social welfare.
3.5.3.3. Subsidies
National governments sometimes grant subsidies to domestic producers to help improve their
trade position. Such devices are an indirect form of protection provided to home businesses,
whether they may be import-competing producers or exporters. By providing domestic firms a
cost advantage, a subsidy allows them to market their products at prices lower than their actual
cost or profit considerations warrant. Governments wanting to see certain domestic industries
expand may provide subsidies to encourage their development through tax concessions,
insurance arrangements, and loans at below market interest rates. Governments may also sell
surplus materials (such as ships) to domestic exporters at favorable prices. Governments may
purchase a firm's product at a relatively high price and then dump it in foreign markets at lower
prices. Two types of subsidy can be distinguished: a domestic subsidy, which is sometimes
granted to producers of import-competing goods, and an export subsidy, which is made to
producers of goods that are to be sold overseas. In both cases, the recipient producer views the
subsidy as tantamount to a negative tax: the government adds an amount to the price the
purchaser pays rather than subtracting from it. The net price actually received by the producer
equals the price paid by the purchaser plus the subsidy. The subsidized producer is thus able to
supply a greater quantity at each consumer's price.
Domestic Subsidy
Attempting to encourage production by its Import-competing producers, a government might

levy tariffs or quotas on imports. But tariffs and quotas involve larger sacrifices in national
welfare than would occur under an equivalent subsidy. Unlike subsidies, tariffs and quotas distort
choices for consumers (resulting in a decrease in the domestic demand for imports), in addition to
permitting less efficient home production to occur. The result is the familiar consumption effect
of protection, whereby a deadweight loss of consumer surplus is borne by the home nation. This
welfare loss is absent in the subsidy case. A subsidy tends to yield the same result for domestic
producers as does an equivalent tariff or quota, but at a lower cost in terms of national welfare.
Subsidies are not free goods, however, for they must be financed by someone. The direct cost of
the subsidy is a burden that must be financed out of tax revenues paid by the public. Moreover,
when a subsidy is given to an industry, it is often in return for accepting government conditions
on key matters (such as employee compensation levels). The superiority of a subsidy over other
types of commercial policies may thus be less than the preceding analysis suggests.
Export Subsidy
Besides of protect import-competing industries, many governments grant subsidies, including
special tax exemptions and the provision of capital at favored rates, to increase the volume of
exports. By providing a cost advantage to domestic producers, such subsidies are intended to
encourage a nation's exports by reducing the price paid by foreigners. Foreign consumers are
favored over domestic consumers to the extent that the foreign price of a subsidized export is less
than the product's domestic price.
The granting of an export subsidy yields two direct effects for home economy: a terms-of-trade
effect and an export revenue effect. Because subsidies tend to reduce the foreign price of home-
nation exports, the home nation's terms trade worsened. But lower foreign prices generally
stimulate export volume. Should the foreign demand for exports be relatively elastic, so that a
given percentage drop in foreign price is more than offset by rise in export volume, the home
nation's export revenues would increase.
Voluntary Export Restraints
Voluntary export restraints are quotas on trade imposed by the exporting country, usually at the
request of the importing country‘s government. You‘re probably wondering why a country
would agree to limit its exports. The answer is because the country believes that if it doesn‘t,
more damaging restrictions might be implemented. A quota rent is the extra profit that producers
make when supply is artificially limited by an import quota.
Local Content Requirements
Local content requirements are another form of trade barrier where the government demands that
some specific fraction of a good be produced domestically. Like other types of trade restrictions,
local content requirements benefit producers, but not consumers.
Administrative Polices
Administrative trade policies are bureaucratic rules that are designed to make it difficult for
imports to enter a country. The Japanese are known for this type of trade barrier which can be
very frustrating for companies trying to break into the market. As with other trade barriers, these
policies hurt consumers by denying access to foreign products that may be superior to what‘s
available at home.
Antidumping Policies
Dumping is defined as selling goods in a foreign market below their cost of production, or as
selling goods in a foreign market at below their fair market value. Dumping is viewed as a
method by which firms unload excess production in foreign markets, and some dumping is
considered to be predatory behaviour where producers use profits from their home markets to
subsidize prices in foreign markets with a goal of driving indigenous competitors out of the
market, and then later raising prices and earning substantial profits. To stop this type of
behaviour, countries implement antidumping policies or countervailing duties which are
designed to punish foreign firms that are dumping and protect domestic producers from this type
of unfair competition.
Why do governments intervene in trade? There are two types of arguments. Political
arguments- concerned with protecting the interests of certain groups within a nation (normally
producers), often at the expense of other groups (normally consumers) and Economic
arguments- concerned with boosting the overall wealth of a nation (to the benefit of all, both
producers and consumers). There are six main political arguments for government intervention
including protecting jobs, protecting industries deemed important for national security,
retaliating to unfair foreign competition, protecting consumers from dangerous products,
furthering foreign policy goals, and protecting the human rights of individuals in exporting
countries.
3.6. Intellectual Property and Intellectual Property Rights
Intellectual property (IP) pertains to any original creation of the human intellect such as artistic,
literary, technical, or scientific creation. Intellectual property rights (IPR) refers to the legal
rights given to the inventor or creator to protect his invention or creation for a certain period of
time.
What is the difference between intellectual property and intellectual property rights?
The term intellectual property (IP) is sometimes used as something separate from intellectual
property rights (IPR). In such cases, the term IP means the (abstract) product of the intellect and
the term IPR means a legal right covering IP A distinctive product name can be registered as a
trademark.
What is meant by intellectual property? Intellectual property (IP) refers to creations of the mind,
such as inventions; literary and artistic works; designs; and symbols, names and images used in
commerce.
Are intellectual property rights property? Intellectual Property rights (IP rights) are a form of
property granted through trademarks, patents, industrial designs, copyrights and geographical
indications, among others, that enable the owner to exercise monopoly on the subject of the IP
rights.
What is the importance of intellectual property rights? Why is IPR Important? Intellectual
property protection is critical to fostering innovation. Without protection of ideas, businesses and
individuals would not reap the full benefits of their inventions and would focus less on research
and development.
What are the 7 intellectual property rights? Intellectual property rights include patents, copyright,
industrial design rights, trademarks, plant variety rights, trade dress, geographical indications,
and in some jurisdictions trade secrets.
What are the roles of intellectual property? Intellectual property stirs interests among people
concerned. It provides income and causes movement of all kinds of resources and therefore

creates industry and commerce. The intellectual property has a very important role both in
economic and social development of mankind.
Why intellectual property is so important for any business? Intellectual property helps in
developing and maintaining company's long term revenue streams and increase shareholder's
value. IP also helps companies to protect technology innovations and gain competitive
advantage One of the many ways to protect innovation is to file a patent for the invention.
What rights are protected by intellectual property laws?
Copyrights – these protect literary and artistic works and give the owner of the work exclusive
rights to their use, distribution, and sale. ... Patents – these protect inventions and give the
inventor the right to bar anyone from recreating, using, or selling his or her invention.

CHAPTER FOUR
TRADE, GROWTH AND DEVELOPMENT
4.1. Trade Strategies for Development: Export Promotion versus Import Substitution
A convenient and instructive way to approach the complex issues of appropriate trade policies
for development is to set these specific policies in the context of a broader LDC strategy of
looking outward or looking inward. In the words of Paul P. Streeten, outward-looking
development policies "encourage not only free trade but also the free movement of capital,
workers, enterprises and the multinational enterprise, and an open system of communications.
By contrast, inward-looking development policies stress the need for LDCs to evolve their own
styles of development and to control their own destiny. This means policies to encourage
indigenous "learning by doing" in manufacturing and the development of indigenous
technologies appropriate to a country's resource endowments. According to proponents of
inward-looking trade policies, greater self-reliance can be accomplished only if you restrict trade,
the movement of people and communications, and if you keep out the multinational enterprise,
with its wrong products and wrong want -stimulation and hence its wrong technology.
Within these two broad philosophical approaches to development, a lively debate has been
carried on in the development literature since the early 1950s. This is the debate between the free
traders, who advocate outward-looking (export promotion) strategies of industrialization, and the
protectionists, who are proponents of inward-looking (import substitution) strategies. The
balance of the debate has oscillated back and forth, with the import substitutors predominating in
the 1950s and 1960s and the export promoters gaining the upper hand in the late 1970s and,
especially among western and World Bank economists, in the 1980s and 1990s. Among many
Third World economists and certain developed-country advocates of the "new" or "strategic"
trade theories, however, the philosophical foundations of import substitution and collective self-
reliance remained almost as strong in the 1990s as they were in prior decades.
Basically, the distinction between these two trade-related development strategies is that
advocates of import substitution (IS) believe that LDCs should initially substitute domestic
production of previously imported simple consumer goods (first -stage IS) and then substitute

Econ 3081, International Economics I
through domestic production for a wider range of more sophisticated manufactured items
(second - stage IS) all behind the protection of high tariffs and quotas on these imports. In the
long run, IS advocates cite the benefits of greater domestic industrial diversification and the
ultimate ability to export previously protected manufactured goods as economies of scale, low
labor costs, and the positive externalities of learning by doing cause domestic prices to become
more competitive with world prices.
By contrast, advocates of export promotion (EP) of both primary and manufactured goods cite
the efficiency and growth benefits of free trade and competition, the importance of substituting
large world markets for narrow domestic markets, the distorting price and cost effects of
protection, and the tremendous successes of the East Asian export-oriented economies of South
Korea, Taiwan, Singapore, and Hong Kong. In practice, the distinction between IS and EP
strategies is much less pronounced than many advocates would imply. Most LDCs have
employed both strategies with different degrees of emphasis at one time or another. For example,
in the 1950s and 1960s, the inward-looking industrialization strategies of the larger Latin
American and Asian countries such as Chile, Peru, Argentina, India, Pakistan, the Philippines,
and Bangladesh were heavily IS-oriented. By the end of the 1960s, some of the key sub-Saharan
African countries like Nigeria, Ethiopia, Ghana, and Zambia began to pursue IS strategies, and
some smaller Latin American and Asian countries also joined in.
However, since the mid-1970s, the EP strategy has been increasingly adopted by a growing
number of countries. The early EP adherents-South Korea, Taiwan, Singapore, and Hong Kong-
were thus joined by the likes of Brazil, Chile, Thailand, and Turkey, which switched from an
earlier IS strategy. It must be stressed, however, that even the four most successful East Asian
export promoters have pursued protectionist IS strategies sequentially and simultaneously in
certain industries. So it is inaccurate to call them free traders, although they are definitely
outward-oriented. Against this background, we can now examine the issue of outward-looking
export promotion versus inward-looking import substitution in more detail by applying the
following fourfold categorization:
1. Primary outward-looking policies (encouragement of agricultural and raw material
exports)
Bonga University, Economics Department Page 49
2. Secondary outward-looking policies (promotion of manufactured exports)

3. Primary inward-looking policies (mainly agricultural self-sufficiency)
4. Secondary inward-looking policies (manufactured commodity self-sufficiency
through import substitution)
4.2. Export Promotion: Looking Outward and Seeing Trade Barriers

The promotion of LDC primary or secondary exports has long been considered a major
ingredient in any viable long-run development strategy. The colonial territories of Africa and
Asia, with their foreign-owned mines and plantations, were classic examples of primary
outward-looking regions. It was partly in reaction to this enclave economic structure and partly
as a consequence of the industrialization bias of the 1950s and 1960s that newly independent
states, as well as older LDCs, put great emphasis on the production of manufactured goods
initially for the home market (secondary inward) and then for export (secondary outward). Let us
therefore look briefly at the scope and limitations of LDC export expansion, first with respect to
primary products and then with respect to manufactured exports.
Primary-Commodity Export Expansion: Limited Demand, Shrinking Markets

Many low-income LDCs still rely on primary products for most of their export earnings.
Nevertheless, with the notable exception of petroleum exports and a few needed minerals,
primary-product exports have grown more slowly than total world trade. Moreover, the LDC
share of these exports has been falling over the past few decades. Because food, non-food
agricultural products, and raw materials make up almost 40% of all LDC exports and for many
poor countries constitute their principal source of foreign-exchange earnings, we need to
examine the factors affecting the demand for and supply of primary product exports.
Demand Side
On the demand side, there appear to be at least five factors working against the rapid expansion
of Third World primary-product and especially agricultural exports to the developed nations
(their major markets). First, the income elasticity of demand for agricultural food stuffs and raw
materials are relatively low compared with those for fuels, certain minerals, and manufactures.
For example, the income elasticity of demand for sugar, cacao, tea, coffee, and bananas have all
been estimated at less than one. This not only contributes to problems of export earnings
instability but also means that only a sustained high rate of per capita income growth in the
developed countries can lead to even modest export expansion of these particular commodities
from the LDCs.
Second, developed-country population growth rates are now at or near the replacement level. So,
little expansion can be expected from this source.
Third, the price elasticity of demand for most primary commodities is relatively low. When
relative agricultural prices are falling, such low elasticities mean less total revenue for exporting
nations.
A device that is widely used to attempt to modify the tendency for primary product prices to
decline relative to other traded goods is that of establishing International Commodity
Agreements. Such agreements are intended to set overall output levels, to stabilize world prices,
and to assign quota shares to various producing nations for such items as coffee, tea, copper,
lead, and sugar. To work effectively, they require cooperation and compromise among
participants. Commodity agreements can also provide greater protection to individual exporting
nations against excessive competition and the over-expansion of world production. Such over-
expansion of supply tends to drive down prices and curtail the growth of earnings for all
countries.
In short, commodity agreements attempt to guarantee participating nations a relatively fixed
share of world export earnings and a more stable world price for their commodity. It is for this
reason that at its fourth world conference, held in Nairobi, Kenya in May 1976, the United
Nations Conference on Trade and Development (UNCTAD) advocated the establishment of an
$11 billion common fund to finance "buffer stocks" to support the prices of some 19 primary
commodities (including sugar, coffee, tea, bauxite, jute, cotton, tin, and vegetable oil) produced
by various third world nations. Unfortunately for LDC exporters, there has been little progress on
the UNCTAD proposal, and most existing non-oil commodity agreements have either failed (tin)
or been largely ignored by producers (coffee and sugar).
The fourth and fifth factors working against the long-run expansion of LDC primary-product
export earnings - the development of synthetic substitutes and the growth of agricultural
protection in the developed countries-are perhaps the most important. Synthetic substitutes for
commodities like cotton, rubber, sisal, jute, hide, skins, and recently even copper (with glass
fibers for communication networks) act both as a brake against higher commodity prices and as a
direct source of competition in world export markets. In the case of agricultural protection,
which usually takes the form of tariffs, quotas, and non-tariff barriers such as sanitary laws
regulating food and fiber imports, the effects can be devastating to third world export earnings.
The common agricultural policy of the European Union, for example, is much more
discriminatory against LDC food exports than the policies that had formerly prevailed in the
individual member nations.
Supply Side
On the supply side, a number of factors also work against the rapid expansion of primary-product
export earnings. The most important is the structural rigidity of many third world rural
production systems. These rigidities include limited resources; poor climate; bad soils;
antiquated rural institutional, social, and economic structures; and nonproductive patterns of land
tenure. Whatever the international demand situation for particular commodities, little export
expansion can be expected when rural economic and social structures militate against positive
supply responses from peasant farmers who are averse to risk.
Finally, we should mention here the pernicious effects of developed-country trade policies (such
as the United States' sugar quota) and foreign aid policies that depress agricultural prices in
LDCs and discourage production. For example, the European Union's policy of selling
subsidized beef to the nations of West Africa in the appearance of foreign assistance has
devastated cattle prices in those countries. We may conclude, therefore, that the successful
promotion of primary-product exports cannot occur unless there is a reorganization of rural
social and economic structures to raise total agricultural productivity and distribute the benefits
more widely. The primary objective of any third world rural development strategy must be to
provide sufficient food to feed the indigenous people first and only then be concerned about
export expansion. But having accomplished this most difficult internal development task, LDCs
may be able to realize the potential benefits of their comparative advantage in world primary
commodity markets only if they can
 Cooperate with one another,
 Be assisted by developed nations in formulating and carrying out workable
international commodity agreements, and
 Secure greater access to developed country markets.

Expanding Exports of Manufactured Goods: Some Successes, Many Barriers
The expansion of LDC manufactured exports has been given great stimulus by the spectacular
export performances of countries like South Korea, Singapore, Hong Kong, Taiwan, Mexico,
and Brazil over the past four decades. For example, Taiwan's total exports grew at an annual rate
of over 20%, and exports from South Korea grew even faster. In both cases, this export growth
was led by manufactured goods, which contributed over 80% of both nations' foreign exchange
earnings. For the third world as a whole, manufactured exports grew from 6% of total exports in
1950 to nearly 45% by 1990.
The export successes of recent decades, especially among the Four Asian Tigers have provided
the primary impetus for arguments by neoclassical counter revolutionaries particularly those at
the World Bank and the IMF. According to them, LDC economic growth is best served by
allowing market forces, free enterprise, and open economies to prevail while minimizing
government intervention. Unfortunately, the reality of the East Asian cases does not support this
view of how their export success was achieved. In South Korea, Taiwan, and Singapore, the
production and composition of exports was not left to the market, but resulted as much from
carefully planned intervention by the government.
Although income and price Elasticities of international demand for manufactured goods in the
aggregate are higher than for primary commodities, they afforded little relief to many developing
nations bent on expanding their exports. For many years there was wide spread protection in
developed nations against the manufactured exports of LDCs-which was in part the direct result
of the successful penetration of low-cost labor-intensive manufactures from countries like
Taiwan, Hong Kong, and South Korea during the 1960s and 1970s. As in the case of agricultural
and other primary production, the uncertain export outlook should be no cause for curtailing the
needed expansion of manufacturing production to serve local LDC markets.
There is great scope for mutually beneficial trade in manufactures among developing countries
themselves with-in the context of the gradual economic integration of their national economies.
Too much emphasis has been placed on the analysis of trade prospects of individual LDCs with

the developed nations (North-South trade) and not enough on the prospects for mutually
beneficial trade with one another (South-South trade).
Import Substitution Industrialization Strategy
During the 1950s and 1960s, developing countries experienced a decline in world markets for
their primary products and growing balance of payments deficits on their current accounts. Given
a general belief in the magic of industrialization as well as the terms of trade arguments of the
Prebisch Singer hypothesis, they turned to an import substitution strategy of urban industrial
development. Some countries still follow this strategy for both economic and political reasons,
although pressure from the IMF and the World Bank lay heavy opportunity costs on such
endeavors. As we noted earlier, import substitution entails an attempt to replace commodities
that are being imported, usually manufactured consumer goods, with domestic sources of
production and supply.
The typical strategy is first to erect tariff barriers or quotas on certain imported commodities,
then to try to set up a local industry to produce these goods-items such as radios, bicycles, or
household electrical appliances. Typically, this involves joint ventures with foreign companies,
which are encouraged to set up their plants behind the wall of tariff protection and given all
kinds of tax and investment incentives.
Although initial costs of production may be higher than former import prices, the economic
rationale put forward for the establishment of import-substituting manufacturing operations is
either that the industry will eventually be able to reap the benefits of large-scale production and
lower costs (the so-called infant industry argument for tariff protection) or that the balance of
payments will be improved as fewer consumer goods are imported. Often a combination of both
arguments is advanced. Eventually, it is hoped that infant industry will grow up and be able to
compete in world markets. It will then be able to generate net foreign-exchange earnings once it
has lowered its average costs of production. Let us see how the theory of protection can be used
to demonstrate this process.
4.3. The Theory of Protection
A principal mechanism of the import substitution strategy is the erection of protective tariffs
(taxes on imports) or quotas (limits on the quantity of imports) behind which IS industries are
permitted to operate. The basic economic rationale, for such protection is the infant industry
argument mentioned earlier. Tariff protection against the imported commodity is needed so the
argument goes, in order to allow the now higher-priced domestic producers enough time to learn
the business and to achieve the economies of scale in production and the external economies of
learning by doing that are necessary to lower unit costs and prices. With enough time and
sufficient protection, the infant will eventually grow up, be directly competitive with developed
country producers, and no longer need this protection.
Ultimately, as in the case of many formerly protected IS industries in South Korea and Taiwan,
domestic LDC producers will be able to produce not only for the domestic market without a
tariff wall or government subsidies but also to export their now lower-cost manufactured goods
to the rest of the world. Thus for many third world industries, in theory, an IS strategy becomes
the prerequisite for an EP strategy. It is for this reason, among others (including the desire to
reduce dependence and attain greater self-reliance, the need to build a domestic industrial base,
and the ease of raising substantial tax revenue from tariff collections), that import substitution
appealed to so many LDC governments.
The IS Industrialization Strategy and Results

Most observers agree that the import-substituting strategy of industrialization has been largely
unsuccessful. Specifically, there have been five undesirable outcomes.
First, secured behind protective tariff walls and immune from competitive pressures, many IS
industries (both publicly and privately owned) remain inefficient and costly to operate.
Second, the main beneficiaries of the import substitution process have been the foreign firms that
were able to locate behind tariff walls and take advantage of liberal tax and investment
incentives. After deducting interest, profits, and royalty and management fees, most of which are
remitted abroad, the little that may be left over usually accrues to the wealthy local industrialists
with whom foreign manufacturers cooperate and who provide their political and economic cover.
Third, most import substitution has been made possible by the heavy and often government-
subsidized importation of capital goods and intermediate products by foreign and domestic
companies. In the case of foreign companies, much of this is purchased from parent and sister
companies abroad. There are two immediate results.
 First, capital-intensive industries are set up, usually catering to the consumption
habits of the rich while having a minimal employment effect.
 Second, far from improving the LDCs' balance of payments situation and alleviating
the debt problem, indiscriminate import substitution often worsens the situation by increasing
a need for imported capital-goods inputs and intermediate products.
Fourth detrimental effect of many import substitution strategies has been their impact on
traditional primary-product exports. To encourage local manufacturing through the importation
of cheap capital and intermediate goods, exchange are often artificially overvalued. This has the
effect of raising the price of exports and lowering the price of imports in terms of the local
currency
Fifth, import substitution, which may have been conceived with the idea of stimulating infant
industry growth and self-sustained industrialization by creating "forward" and "backward"
linkages with the rest of the economy, has often inhibited that industrialization. Many infants
never grow up content to hide behind protective tariffs, and governments reluctant to force them
to be more competitive by lowering tariffs. In fact, LDC governments themselves often operate
protected industries as state-owned enterprises.
Tariff Structures and Effective Protection

Because import substitution programs are based on the protection of local industries against
competing imports primarily through the use of tariffs and physical quotas, we need to analyze
the role and limitations of these commercial policy instruments in developing nations. As we
have already discussed, governments impose tariffs and physical quotas on imports for a variety
of reasons. For example, to raise public revenue, avoid unfair competition, realize stability etc.
However, in a small country unable to influence world prices of its exports or imports (in other
words, most LDCs), this argument for tariffs (or devaluation) has little validity. Finally, as we
have just seen, tariffs may form an integral component of an import substitution policy of
industrialization. Whatever the means used to restrict imports, such restriction always protects
domestic firms from competition within producers from other countries. To measure the degree
of protection, we need to ask by how much these restrictions cause the domestic prices of
imports to exceed what their prices would be if there were no protection. There are two basic
measures of protection: the nominal rate and the effective rate. The nominal rate of protection
shows the extent to which the domestic price of imported goods exceeds what their price would
be in the absence of protection. Thus the nominal (ad valorem) tariff rate (t) refers to the final
prices of commodities and can be defined simply as where ‗p'‘ and ‗p‘ are the unit prices of
industry's output with and without tariffs, respectively.
p ' p
t . For example, if the domestic price (p') of an imported automobile is $5,000
p
whereas the CIF (cost plus insurance and freight) price (p) when the automobile arrives at the
port of entry is $4,000, the nominal rate of tariff protection (t) would be 25%. By contrast, the
effective rate of protection shows the percentage by which the value added at a particular stage
of processing in a domestic industry can exceed what it would be without protection. In other
words, it shows by what percentage the sum of wages, interest, profits, and depreciation
allowances payable by local firms can, as a result of protection, exceed what this sum would be
if-these same firms had to face unrestricted competition (no tariff protection) from foreign
producers.
The effective rate (g) can therefore be defined as the difference between value added (percent of
output) in domestic prices and value added in world prices, expressed as a percentage of the
latter, so that where v' and v are the value added per unit of output with and without protection,
respectively. The result can be either positive or negative, depending on whether v' is greater or
less than v. For most LDCs, it is highly positive.
V 'V
g . The important difference between nominal and effective rates of protection can
V
be illustrated by means of an example. Consider a nation without tariffs in which automobiles are
produced and sold at the international or world price of $10,000. The value added by labor in the
final assembly process is assumed to be $2,000, and the total value of the remaining inputs is
$8,000. Assume for simplicity that the prices of these non-labor inputs are equal to their world
prices.

To sum up, the standard argument for tariff protection in developing countries has four major
components: Duties on trade are the major source of government revenue in most LDCs because
they are a relatively easy form of taxation to impose and even easier to collect. Import
restrictions represent an obvious response to chronic balance of payments and debt problems.
Protection against imports is one of the most appropriate means for fostering economies of scale,
positive externalities, and industrial self-reliance as well as overcoming the pervasive state of
economic dependence in which most third world countries finds themselves. By pursuing
policies of import restriction, developing countries can gain greater control over their economic
destinies while encouraging foreign business interests to invest in local import-substituting
industries, generating high profits and thus the potential for greater saving and future growth.
They can also obtain imported equipment at relatively favorable prices and reserve an already
established domestic market for local or locally controlled producers. Eventually, they may even
become competitive enough to export to the world market.
4.4. Summary and Conclusions: Trade Optimists and Trade Pessimists
We are now in a position to summarize the major issues and arguments in the great ongoing
debate between advocates of free-trade, outward -looking development and export promotion
policies-the trade optimists-and advocates of greater protection, more inward-looking strategies,
and greater import substitution-the trade pessimists.
Trade Pessimist Arguments
Trade pessimists tend to focus on three basic themes:
1. The limited growth of world demand for primary exports,
2. The secular deterioration in the terms of trade for primary products. producing nations, and
3. The rise of "new protectionism," against the exports of LDC manufactured and processed
agricultural goods.
LDC exports grow slowly because of

A. A shift in developed countries from low technology, material-intensive goods to high-
technology, skill-intensive products, which decreases the demand for third world raw
materials;
B. Increased efficiency in industrial uses of raw materials;

C. The substitution of synthetics for natural raw materials like rubber, copper, and cotton;
D. The low income elasticity of demand for primary products and light manufactured goods;
E. The rising productivity of agriculture in developed countries; and
F. The rising tide of protectionism for both agriculture and labor-intensive developed-country
industries.
The terms of trade deteriorate because of
 Oligopolistic control of factor and commodity markets in developed countries combined with
increasing competitive sources of supply of LDC exportable goods and
 A generally lower level of the income elasticity of demand for LDC exports.
The rise of new protectionism in the developed world results from the very success of a growing
number of LDCs in producing a wider range of both primary and secondary products at
competitive world market prices, combined with the quite natural fears of workers in higher-cost
developed- country industries that their jobs will be lost. They pressurize their governments in
North America, Europe, and Japan to curtail or prohibit competitive imports from the developing
world.
The trade pessimists therefore conclude that trade hurts third world development because
 The slow growth in demand for their traditional exports means that export expansion
results in lower export prices and a transfer of income from poor to rich nations;
 Without import restrictions, the high elasticity of LDC demand for imports combined with
the low elasticity for their exports means that developing countries must grow slowly to
avoid chronic balance of payments and foreign-exchange crises; and
 Because developing nations have their "static" comparative advantage in primary products,
export-promoting free-trade policies tend to inhibit industrialization, which is in turn the
major vehicle for the accumulation of technical skills and entrepreneurial talents.
Trade Optimist Arguments

Trade optimists tend to under play the role of international demand in determining the gains'
from trade. Instead, they focus on the relationship between LDC trade policy, export
performance, and economic growth. They argue that trade liberalization (including export
promotion, currency devaluation, removal of trade restrictions, and generally "getting prices
right") generates rapid export and economic growth because free trade provides a number of
benefits:
 It promotes competition, improved resource allocation, and economies of scale in areas

where LDCs have comparative advantage. Costs of production are consequently lowered.
 It generates pressures for increased efficiencies, product improvement, and technical
change, thus raising factor productivity and further lowering costs of production.
 It accelerates overall economic growth, which raises profits and promotes greater saving
and investment and thus furthers growth.
 It attracts foreign capital and expertise, which are in scarce supply in LDCs.
 It generates needed foreign exchange that can be used to import food if the agricultural
sector lags behind or suffers droughts or other natural catastrophes.
 It eliminates costly economic distortions caused by government interventions in both the
export and foreign-exchange markets and substitutes market allocation for the corruption and
rent-seeking activities that usually result from an overactive government sector.
 It promotes more equal access to scarce resources, which improves overall resource
allocation
Trade optimists argue, finally, that even though export promotion may at first be difficult with
limited gains-especially in comparison with the easy gains of first -stage import substitution-over
the longer run the economic benefits tend to build up momentum, whereas import substitution
faces rapidly diminishing returns.
Reconciling the Arguments: The Data and the Consensus
We can evaluate the debate on two levels, the empirical and the philosophical. In his study of the
experience of developing countries over the past three decades, Rostam M. Kavopssi argues that
the empirical evidence demonstrates quite clearly that neither the trade optimists nor the trade
pessimists are correct at all times. It all depends on fluctuations in the world economy. Thus
when the world economy was expanding rapidly during the period from 1960 to 1973, the more
open economy LDCs clearly out performed (in terms of aggregate export and economic growth)
the more closed-economy nations. The trade optimists' arguments appear validated during this
period of rapid world growth. But when the world economy slowed down between 1973 and
1977, the more open economies had a more difficult time and the trade pessimists did better. A
follow-up 1988 study by Hans W Singer and Patricia Gray, which extended Kavoussi's empirical
analysis for the period 1977-1983, when world economic conditions were even more
unfavorable, supports the finding that high growth rates of export earnings occur only when
external demand is strong. Changes in trade policy appear to have little or no effect.

CHAPTER FIVE
REGIONAL TRADING ARRANGEMENTS: THE THEORY OF CUSTOMS UNION
5.1 Objectives of the chapter
At the end of this chapter students will be able to:
 Explain the nature of regional trading arrangements, their types, and motives, and
 Explain the welfare implications of regional trading arrangements (specifically, Customs
union)
5.2 Types of regional trading arrangements
What do we mean by economic integration? Since the mid- 1950s, the term economic
integration has attracted a wide attention and has got acceptance. Economic integration is a
process of eliminating restrictions on international trade, payments and factor mobility.
Economic integration thus results in the uniting of two or more national economies in a regional
trading arrangement. There are different degrees of economic integration (regional trading
arrangements). Below are the different types of economic integration.
1. Free- trade area. This is an association of trading nations whose members agree to remove
all tariff and non- tariff barriers among themselves. Each member, however, maintains its
own set of trade restrictions against outsiders. An example of this stage of integration is the
North American Free Trade Agreement (NAFTA), consisting of Canada, Mexico and the
US.
2. Customs Union. A second stage in the process of economic integration is the formation of
customs union. Like a free trade association, a custom union is an agreement among two or
more trading partners to remove all tariff and non- tariff trade barriers among themselves. In
addition, however, each member nation imposes identical trade restrictions against non-
participants. That is, each nation follows a common external trade policy. The effect of the
common external trade policy is to permit free trade within the customs union, while all trade
restrictions imposed against outsiders ( non- members) are equalized. A well example is
Benelux, consisting three members- Belgium, Netherlands and Luxemburg, formed in 1948.
3. Common Market. A further stage in the process of economic integration is a common
market. A common market is a group of trading nations that permits;
1) The free movements of goods and services among member nations
2) The initiation of common external trade restrictions against non-members and
3) The free movement of factors of production across national borders within the
economic bloc (group).
Economic Union
This represents an even further step in economic integration than a common market. In addition
to permitting free movement of goods, services and factors of production, and following a
common external trade policy against non-members, national, social, taxation and fiscal policies
are harmonized and administered by a supranational institution in economic union. In other
words, in addition to abolition of existing trade barriers, economic union requires an agreement
to transfer economic sovereignty to a super natal authority.
Belgium and Luxemburg formed an economic union during 1920s.
Monetary Union
This represents the ultimate degree of economic union and it requires the unification of national
monetary policies and the acceptance of a common currency administered by a supranational
monetary authority. The U.S. serves as an example of a monetary union. Fifty states are linked
together in a complete monetary union with a common currency, implying completely fixed
exchange rates among 50 states.
5.3 The Status of Regional Economic Integration in Africa
1. ECOWAS
The 15 members of the Economic Community of West African States (ECOWAS) are Benin,
Burkina Faso, Cap Verde, Cote d'Ivoire, The Gambia, Ghana, Guinea, Guinea-Bissau, Liberia,
Mali, Niger, Nigeria, Senegal, Sierra Leone, and Togo.
List of the aims and objectives of ECOWAS today
1. Promotion of Cooperation and development. ...
2. Harmonization of Agricultural, Economic, Monetary and Industrial Policies. ...
3. Abolition of trade restrictions and Customs Duties. ...
4. Establishment of Common Fund. ...
5. Implementation of Infrastructural Schemes.
2. COMESA
What are COMESA countries?

COMESA (19) countries include: Burundi, Comoros, Congo, Dem Rep., Djibouti, Egypt,
Eritrea, Ethiopia, Kenya, Libya, Madagascar, Malawi, Mauritius, Rwanda, Seychelles, Sudan,
Swaziland, Uganda, Zambia, and Zimbabwe. The FTA was achieved on 31st October, 2000
when nine of the member States namely Djibouti, Kenya, Madagascar, Malawi, Mauritius,
Sudan, Zambia and Zimbabwe eliminated their tariffs on COMESA originating products, in
accordance with the tariff reduction schedule adopted in 1992.This followed a trade
liberalization programme that commenced in 1984 on reduction and eventual elimination of tariff
and non-tariff barriers to intra- regional trade. Burundi and Rwanda joined the FTA on 1st
January 2004. These eleven FTA members have not only eliminated customs tariffs but are
working on the eventual elimination of quantitative restrictions and other non-tariff barriers.
COMESA Objectives and Priorities
The history of COMESA began in December 1994 when it was formed to replace the former
Preferential Trade Area (PTA) which had existed from the earlier days of 1981. COMESA (as
defined by its Treaty) was established ‗as an organization of free independent sovereign states
which have agreed to co-operate in developing their natural and human resources for the good of
all their people‘ and as such it has a wide-ranging series of objectives which necessarily include
in its priorities the promotion of peace and security in the region.
However, due to COMESA‘s economic history and background its main focus is on the
formation of a large economic and trading unit that is capable of overcoming some of the barriers
that are faced by individual states.. COMESA‘s current strategy can thus be summed up in the
phrase ‗economic prosperity through regional integration‘. With its 21 Member States,
population of over 583 million a Gross Domestic Product of $805 billion, a global export/import
trade in goods worth US$ 324 billion, COMESA forms a major market place for both internal
and external trading. Geographically, COMESA almost two thirds of the African Continent with
an area of 12 Million (sq km).
What COMESA Offers?

COMESA offers its members and partners a wide range of benefits which include:
1) A wider, harmonized and more competitive market
2) Greater industrial productivity and competitiveness

3) Increased agricultural production and food security
4) A more rational exploitation of natural resources
5) More harmonized monetary, banking and financial policies
6) More reliable transport and communications infrastructure
What does IGAD mean?
Intergovernmental Authority on Development: The Intergovernmental Authority on

Development (IGAD) is an eight-country trade bloc in Africa. It includes governments from the
Horn of Africa, Nile Valley and the African Great Lakes. Its headquarters is in Djibouti City.
What was the main reason why IGAD was formed?
The Intergovernmental Authority on Development (IGAD) was created in 1996 to succeed the
Intergovernmental Authority on Drought and Development that was founded in 1986 to deal
with issues related to drought and desertification in the Horn Africa.
3. EAC
The East African Community (EAC) is a regional intergovernmental organization of 6 Partner

States: the Republics of Burundi, Kenya, Rwanda, South Sudan, the United Republic of
Tanzania, and the Republic of Uganda, with its headquarters in Arusha, Tanzania. The common
market thus represents a more complete stage of integration than a free-trade area or customs
union. The European Union (EU) achieved the status of a common market in 1992.
5.4 Reasons for Regionalism
What will be the ultimate cause for Regional trading arrangements? Regional trading
arrangements are pursued for a variety of reasons. A motivation of virtually every regional
trading arrangement has been the goal of enhanced economic growth. An expanded regional
market can allow economies of large scale production, foster specialization and learning- by
doing, and attract foreign investment. Regional initiatives can also foster a variety of non-
economic objectives, such as managing immigration flows and promoting regional security.
Moreover, smaller nations may seek safe- haven trading arrangement with larger nations when
future access to the larger nations‘ markets appears uncertain.

This was an apparent motivation for the formation of NAFTA. In North America, Mexico was
motivated to join NAFTA partially by fear of changes in the U.S trade policy towards a more
managed or strategic trade relation.
Furthermore, as new regional trading arrangements are formed or existing ones are expanded or
deepened, the opportunity cost of remaining outside an arrangement increases. Non-member
exporters could realize costly decreases in market share if their sales are diverted to companies
of the member nations. This prospect may be sufficient to tip the political balance in favour of
becoming a member of a regional trading arrangement, as exporting interest of a non-member
nation out weight its import competing interests. For instance, the negotiations between the U.S
and Mexico to form a free trade area appeared to have strongly influenced Canada‘s decision to
join NAFTA, and thus not get left behind in the movement toward free trade in North America.
5.5. Effects of a regional trading Arrangement

What are the possible welfare implications of regional trading arrangements?
In this section, we will see the theoretical benefits and costs of customs union from two
perspectives: static and dynamic. First, let‘s see the static effects of economic integration
(customs union) on productive efficiency and consumer welfare.
Static effects
To understand the static welfare effects of customs union, assume a world composed of three
countries: Luxembourg, Germany and U.S. Suppose that Luxembourg and Germany decide to
form a customs union, and the U.S. is a non-member. The decision to form a custom union
requires that Luxembourg and Germany abolish all tariff restrictions between themselves while
maintaining a common tariff policy against the US. Referring to the following figure, assume the
static welfare effect of a customs union.

Fig 5.1 Static Welfare Effects of a customs Union
The formation of customs union leads to a welfare- increasing trade- creation effect and a
welfare-decreasing trade-diversion effect. The overall effect of the customs union on the welfare
of its members, as well as on the world as a whole, depends on the relative strength of these two
opposing forces. Supply and demand schedules of Luxembourg to be S L and DL.Assume also
that Luxembourg is very small relative to Germany and to the U.S. This means that Luxembourg
cannot influence foreign prices, so that foreign supply schedules of grain are perfectly elastic.
Let Germany‘s supply price be $3.25 per bushel and that of US $3 per bushel. Note that the US
is assumed to be the more efficient supplier as it can offer the grain at a lower price.
1. Before the formation of the customs union (and under the conditions of free trade), Luxembourg
finds it advantageous to purchase all of its import requirements from the United States. Germany
doesn‘t participate in the market because its supply price exceeds that of the US. In free – trade

equilibrium, Luxembourg‘s consumption equals 23 bushels, production equals 1 bushel, and

imports equal 22 bushels.
2. Now suppose Luxembourg levies a tariff 50 cents on each bushel imported from the United
States (or Germany). This raises the Germany‘s supply price to $ 3.75 and the United States
supply price to $ 3.5 still, Luxembourg will find it advantageous to import from US. But since
the imposed tariff has increased the price, Luxembourg imports less bushels of grain (the level of
import decreases from 22 bushels to 10 bushels)
3. Now suppose that, as part of a trade liberalization agreement, Luxembourg and Germany form a
customs union. Luxembourg‘s import tariff against Germany is dropped, but it is still maintained
on imports from the non-member United States. This makes Germany a low- price supplier and
Luxembourg now purchases all of its imports (16 bushels) from Germany at $ 3.25 per bushel,
while importing nothing from the US. The movement towards free trade under a customs union
affects world welfare in two opposing ways:
- A welfare – increasing trade- creation effectand
- A welfare – reducing trade – diversion effect
The overall consequence of a customs union on the welfare of its members, as well as on the
world as a whole, depends on the relative strengths of these two opposing forces.
To distinguish the welfare effects of customs union, we compare the equilibrium condition after
the formation of customs union with the equilibrium condition before formation customs union
when Luxembourg has imposed a uniform tariff on both U.S and Germany.
Trade creation occurs when some domestic production of one customs – union member is
replaced by another member‘s lower- cost imports. In our example, trade- creation occurs when
the Luxembourg‘s domestic production of grain is replaced by the Germany‘s lower- cost
imports. That is, before the formation of customs union Luxembourg used to produce 7 bushels
of grain, while importing 10 bushels from US. After the formation of customs union agreement
with Germany, Luxembourg can now import grain at $ 3.25 per bushel. This reduces domestic
production from 7 bushels to 4 bushels in Luxembourg. Hence, customs union agreement
between Germany and Luxembourg has the effect of increased production specialization in
Germany according to the principle of comparative advantage. This increases the welfare of both
countries: Luxembourg consumers are now paying a lower price ($3.25 per bushel) than before
($3.5 per bushel) and Germany‘s producers have now got the chance to produce more and export
their product. The trade creation effect consists of a consumption effect and a production effect.
Consumption effect
Before the formation of customs union and under its own tariff umbrella, Luxembourg imports
from the US at a price of $ 3.50 per bushel. Luxembourg‘s entry into the customs union results in
its dropping all tariffs against Germany. Facing a lower import price of $ 3.25, Luxembourg
increases its consumption of grain by 3 bushels (from 17 to 20 bushels). The welfare gain
associated with this increase in consumption equals area of triangle b in the above figure.
Production effect
The formation of the customs union also yields a production effect those results in a more
efficient use of world resources. Eliminating the tariff barrier against Germany means that
Luxembourg producers must now compete against lower- cost, more efficient German
producers. Inefficient domestic producers drop out of the market, resulting in a decline in home
output of 3 bushels (from 7 to 4 bushels). The reduction in the cost of obtaining this output (the 3
bushels) equals triangles a in the figure. This area represents the favorable production effect. The
overall trade- creation effect is given by the sum of triangles a + b.
Although a customs union may add to the world welfare by way of trade creation, its trade
diversion effect generally implies a welfare loss.
Trade diversion occurs when imports from a low cost supplier outside the union (U.S) are
replaced by purchases from a higher cost supplier within the union (Germany). This suggests that
world production is reorganized less efficiently. In the previous figure, although the volume of
trade increases (from 10 to 16 bushels of grain) under the customs union, part of this trade (10
bushels) has been diverted from a low cost supplier, the United States, to a high cost supplier,
Germany. The increase in the cost of obtaining these 10 bushels of imported grain equals area C.
This is the welfare loss to Luxembourg and the world as a whole.
Generally speaking, our static analysis concludes that the formation of a customs union will
increase the welfare of its members, as well as the rest of the world, if the positive trade- creation
effect more than offsets the negative trade- diversion effect. Referring to the figure, this occurs if
a + b is greater than c.
One important implication of this analysis is that the success of a customs union depends on the
factors contributing to trade creation and diversion. Several factors that bear on the relative size
of these effects can be identified. One factor is the kind of nations that tend to benefit from a
customs union. Nations whose pre union economies are quite competitive are likely to benefit
from trade creation because the formation of the union offers greater opportunity for
specialization in production. Also, the larger the size and the greater the number of nations in the
union, the greater the gains are likely to be, because there is a greater possibility that the world‘s
low cost producers will be union members. In the extreme case, in which the union consists of
the entire world, there can exist only trade creation, not trade diversion. In addition, the scope for
trade diversion is smaller when being less the customs union‘s common external tariff is lower
rather than higher. Because a lower tariff allows greater trade to take place with non-member
nations, there will replacement of cheaper imports from non-member nations by relatively high-
cost imports from partner nations.
5.6.International Trade regulations

5.6.1. General Agreement on Tariffs and Trade (GATT)
In the period between the first and Second World War, there was a marked deterioration in
international economic relations. In 1920s an attempt was made to go back to normal conditions.
An attempt was also made to organize world trade on a liberal basis.
Partly in response to trade disruptions during the Great Depression, the United States and some
of its allies sought to impose order on trade flows after World War II. The first major post war
step toward liberalization of world trade was the General agreement on tariffs and trade (GATT),
signed in1947. GATT was crafted as an agreement among contracting parties (member nations)
to decrease trade barriers and to place all nations on an equal footing in trading relationships.
GATT was never intended to become an organization; instead it was a set of bilateral agreements
among countries around the world to reduce trade barriers.

The GATT objectives and operation system
The GATT was established with three basic objectives, all of which may be explained by the
desire of the signatories to reverse the move to protectionism in the 1930, and to prevent such a
move being repeated. These are:
1. To provide a frame work for the conduct of trade relations.
2. To provide a frame work for, and to promote the progressive elimination of trade barriers
3. To provide a set of rules(codes of conduct) that would inhibit countries from taking
unilateral action
The GATT has been successful in achieving the first two objectives, most notably in securing
substantial reductions in tariffs although it has been claimed that the reductions have been
concentrated on trade in industrial goods between the developed countries, and there is concern
about proliferation of non-tariff barriers. For instance, the first round of GATT negotiations
completed in 1947, achieved tariff reductions averaging 21 percent.
GATT was based on several principles designed to foster more liberalized trade. One was non-
discrimination, embodying the principles of normal trade relations and national treatment. Under
the normal trade relations principle, all member nations are bound to grant each other treatment
as favorable as they give to any nation with regard to trade matters. This allows comparative
advantage to be the main determinant of trade patterns, which promotes global efficiency. Under
the national treatment principle, member nation must treat other nation industries no less
favorably than they do their own domestic industries, once foreign goods have entered the
domestic market; thus, in principle, domestic regulations and taxes cannot be biased against
foreign products.
The second basic principles of the GATT system was the principle of reciprocity, which requires
that a country receiving a concession from another should offer an equivalent concession in
return. The idea behind this principle can best be described by a well-known Amharic proverb
―Ekekilign-Likekeilish‖. In its most simple form reciprocity might involve two countries
agreeing tariff reductions on each other‘s exports that would leave their bilateral balance of trade
unchanged. The rationale for banning quotas, etc is that a quantitative restriction is a less

transparent instrument for reducing imports than a tariff. This has two aspects. First when facing
a tariff, producers exporting to the country concerned have clear information on the barrier they
have to surmount in order to sell their goods and services, and may choose the volume they
supply subject to that information. With a quantitative restriction, on the other hand, they face
uncertainty about the volume they are allowed to export and about their unit revenue. Second,
with a tariff, the price increasing effect is immediately apparent to consumer in the importing
country. For instance, a 20 percents tariff mercenarily means that the domestic price is 20
percent higher than the world price.
Exceptions to the GATT principles

Though the GATT system was based on the above principles, it has allowed various exceptions
to its general principles. Some relate to the economic problems faced by signatories, some to
particular systems of tariff references, other to trade in specific commodities, and yet others to
permitted reactions to ‗GATT- illegal‘ actions by other members. These exceptions are:
A- Balance of payment problems
GATT members are allowed to apply quantitative import restrictions in order to deal with severe
balance of payments problems. Although it is evident that many LDCs do have severe and
continued balance of payment problems, it is difficult to see why a quantitative restriction should
be the preferred instrument for restricting imports. One possible argument is that markets are less
developed in many LDC, so that an import quota may be more easy to administer than a tariff
and may have a more certain effect.
B. Regional groupings
The major exception to the GATT general principles is that it allows the establishment of free
trade areas and customs union. However, such economic integrations should not increase tariffs
and other barriers to trade with non-members among the GATT countries
C. Tariff preferences
GATT has also allowed tariff preferences for specified groups of countries. Systems of
preferences which were in operation before the signing of the GATT were allowed to continue.
Problems of the GATT system
The GATT principle of non-discrimination made trade liberalization a public good. What was
produced by one nation in negotiation with another was available to all. This gave rise to the
coordination problems shared by all public goods: that of getting each party to participate rather
than sit back and let others do the liberalizing, thus free riding on their efforts. A weakness of
GATT trade negotiations from the 1940s to the 1970s was the limited member of nations that
were actively negotiating participants; many nations – especially the developing nations
remained on the sidelines as free riders on others‘ liberalization: they maintained protectionist
policies to support domestic producers while realizing benefits from trade liberalization abroad.
Another problem confronting the GATT system was its weakness in the settlement of trade
disputes. Historically, trade disputes consisted of matters strictly between the disputants; no third
party was available to which they might appeal for a favorable remedy. As a result, conflicts
often remained unresolved for years, and when they were settled, the stronger country generally
won at the expense of the weaker grievance. GATT improved the conflict resolution process by
formulating compliant procedures and providing a conciliation panel to which a victimized
country could express its grievance. GATT‘s dispute – settlement process, however, did not
include the authority to enforce the conciliation panel‘s recommendations- a weakness that
inspired the formation of the world trade organization (WTO).
5.6.2. World Trade Organization (WTO)

In 1995, GATT was transformed in to WTO. The WTO embodies the main provisions of GATT,
but its role was expanded to include mechanism intended to improve GATT‘s process for
resolving trade disputes among member nations. This transformation turned GATT from a trade
accord in to a membership organization which is responsible for governing the conduct of trade
relations among its members. GATT obligations remain at the core of WTO. However, the WTO
agreement requires that its members adhere not only to GATT rules, but also to the broad range
of trade pacts that have been negotiated under GATT auspices in recent decades. This
undertaking ends the free ride of many GATT members (especially developing countries) that
benefited from, but refused to join, new agreements negotiated in GATT since the 1970s.

Objectives of WTO
The major objectives of WTO are the following.
1. Achieving over all sustainable development by promoting the protection and preservation
of environment, and augmenting resources commensurate with the respective needs and
concerns at different levels of economic development.
2. Ensuring that the developing countries may get a share in the growth of international
trade consistent with their needs of economic development
3. Settling trade disputes
4. To develop a more viable and durable multilateral trading system
5. Coordinating policies in the field of trade, environment and economic development, etc.
5.6.3. Differences between WTO and GATT

The WTO is different from the old GATT in different aspects
1. The WTO is a full – fledged international organization, head quartered in Geneva,
Switzerland; the old GATT was basically a provisional treaty serviced by an ad hoc
secretariat.
2. The WTO has a far wider scope than the old GATT, bringing in to the multilateral
trading system, for the first time, trade in services, intellectual property, and investment.
3. The WTO also administers a unified package of agreements to which all members are
committed; in contrast, the GATT frame work included many side agreements (for
example, antidumping duties and subsidies) whose membership was limited to a few
nations.
4. Moreover, WTO reverses policies of protection in certain ―Sensitive‖ areas (for example,
agriculture and textiles) that were more or less tolerated in the old GATT. The WTO is
not a government; individual nations remain free to set their own appropriate levels of
environment, labor, health, and safety protections.

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International Economics I Econ 3081

COLLEGE OF BUSINESS AND ECONOMICS

Compiled By: Wondimu W.(MSc.)

Bonga University, Economics Department i

Bonga University, Economics Department iii

1.1. The subject matter of international economics

 gains from trade,

 Balance of payments and FDI.

Apart from this, international economics describes

 Investment between countries.

 Distribution of income is covered in the study of internal economics.

Thus, it is important to study the international economics as a special field of economics.

1.2. The Components of International Economics

Bonga University, Economics Department 2

d. exchange control and convertibility,

1.3. The Importance of International Economics

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1.4. International Economics and Economic Theories

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1.5. Purpose of Economic Theories and Models

1.6. Testing a Hypothesis /theory/Models

1.7. International trade theory and policy

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1.8. Reasons for international trade and its significance

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1.9. Current international economic problems

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2.1. Pre-Classical theory of International Trade (Mercantilism)

2.2. The Classical Theory of International Trade

Bonga University, Economics Department 8

2.2.1 Adam Smith’s theory of Absolute Advantage

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Autarky (Closed Economy) Situation

Commodities Unit of output Opportunity cost ratio

Country Rubber Textile (GDP ) (R:T)

The case of Open Economy

Commodities Unit of output

Country Rubber Textile (GDP )

World 100 100 200

Bonga University, Economics Department 10

What about consumption gains?

Case 1. Trade at TOT = 1:1

Table 3: Consumption shares after international trade at TOT=1:1

Country Rubber Textile

Bonga University, Economics Department 11

World 100 100 200 50

Bonga University, Economics Department 12

World 100 100 200 50

Case 4: Trade at TOT = 2:3

Commodities Total Consumption Consumption Gains

Country Rubber Textile

Case 5: Trade at TOT = 3:2

Commodities Total Consumption Consumption Gains

Country Rubber Textile

World 100 100 200 50

Bonga University, Economics Department 13

2.2.2 David Ricardo's Comparative Advantage Model

Assumption of Ricardo’s Model