MODULE 5

INTERNATIONAL TRADE

International trade or foreign trade means trade between countries. It is the

exchange of goods or services between two or more countries. International
economics is the branch of economics which deals with foreign trade. International
economics deals with the economic and financial transactions among nations. It
analyzes the flow of goods services and payments between a nation and the rest of
the world.
Advantages and disadvantages of foreign trade
The important advantages of foreign trade are
Optimal use of natural resources: international trade helps each country to make
optimum use of its natural resources. Each country can concentrate on production of
those goods which are advantageous to them. Therefore wastage of resources is
avoided.
Availability of all types of goods: Foreign trade enables a country to obtain goods
produced all over the world.
Specialization: Foreign trade leads to specialization as the country produce only
those goods where the production of such goods has certain advantages. The
country can enjoy the benefits of division of labor.
Advantages of large scale production : Because of foreign trade and foreign
market, goods can be produced for home consumption as well as for export. This
helps a country to produce in large scale and enjoy the benefits of large scale
production.
Stability in prices : International trade helps to avoid fluctuations in prices by
making the goods freely available all over the world.
Establishment of new industries: The importing of machinery and technology
enable countries to start new industries.
Increase in efficiency: Due to international competition the producers in a country
attempt to produce better quality goods to minimize cost. This increases efficiency
and productivity.
Development of the means of transport and communication:As international trade
requires the best means of transport and communication, countries develop these
facilities.
International cooperation and understanding :The people of different countries
come in contact with each other and it creates cooperation, understanding and
cordial relations among various nations.
Discouragement of monopolies:International trade discourages the formation of
monopolies in a country. The government imports the goods where monopoly
practices are prevalent.
Better employment opportunities:Along with the expansion of foreign trade more
jobs and better employment opportunities for the people both in and outside the
country are created.
Disadvantages
Threat to domestic industries:International trade has an adverse effect on the
development of home industries. The survival of infant industries at home is
difficult due to foreign competition and unrestricted imports.
Economic dependence:Underdeveloped nations have to depend on developed
countries for their economic growth.
Misuse of natural resources:Too much of exports can exhaust the natural resources
in a country.
Import of harmful goods:Through international trade harmful goods may be
imported which will affect the health and well being of the people.
Evil effects of dumping:Certain countries use international trade to dump their
goods in other countries.
Against National Defense :It is argued that a nation which depends on foreign
sources of supply lacks defence during the war.

THEORIES OF INTERNATIONAL TRADE

Absolute advantage theory:
According to Adam Smith, the basis of international trade is absolute cost
advantage. Suppose there are two commodities and two countries which produce
these commodities .One country is efficient in the production of one commodity
and thus it has an absolute advantage in the production of this commodity. The
other country has an absolute advantage over the production of the other
commodity ; then the countries will specialize and produce that commodity upon
which they have an absolute advantage ;they will export this commodity to the
other country; by this process resources are utilized in the most efficient way and
output of both the countries will increase. From this mutual trade both the countries
will benefit.
The absolute advantage theory can be explained with the help of an example.
USA UK
Number of Units of wheat per unit of labour 10 5
Number of units of cloth per unit of labour 3 8

In the above example, USA has an absolute advantage over the production of wheat
over UK because it is able to produce 10 units of wheat with one unit of Labor. But
UK can produce only 5 units. Similarly UK has an absolute advantage over the
production of cloth. Hence US will produce and export wheat to UK and UK will
produce and export cloth to US. Both the countries will gain from international
trade. This kind of production leads to specialization and division of labor. But
according to Adam Smith, division of Labor is limited to the size of the market.
Adam Smith’s theory is criticised that it is too narrow in its scope because it
explains only one aspect of trade, that is absolute advantage.
Comparative advantage theory
Comparative cost advantage theory was developed by David Ricardo in 1857. JS
mill, Marshall and others refined it later. According to Ricardo, even in the case of
a country for which there is no absolute advantage for both the commodities, it can
gain from international trade. In this situation, the country should specialize in the
production and export of the commodity in which its absolute disadvantages smaller
and import the commodity in which its absolute disadvantage is greater. In other
words, a country should specialize in the production of that commodity in which it
is more efficient and leave the production of the other commodity to the other
country.
Assumptions
Comparative cost advantage theory of Ricardo is based on the following
assumptions.
• There are only two countries and two commodities.
• There are no barriers in international trade.
• There is no transport cost.
• Labor is the only component of cost of production.
• There is perfect competition and full employment.
• Labor is homogeneous.
• Labor is perfectly mobile within the country.
Goods are exchanged according to the relative amount of labor embodied in
them.This theory is explained with the help of the following example
In his two commodity two country model, Ricardo has taken cloth and wine as two
commodities and England and Portugal as two countries.

Country No.of units of labour No.of units of labour Exchange ratio

per unit of cloth per unit of wine
England 100 120 1 wine = 1.2 cloth
Portugal 90 80 1 wine =0.88 cloth

The above example shows that Portugal has an absolute advantage in the production
of both the commodities. However, a comparison of the ratio of the cost of wine
production with ratio of the cost of cloth production in these two countries reveals
that Portugal has a higher advantage in the production of wine. Hence Portugal will
specialize in wine production and produce wine. At the same time, England has a
comparative advantage in cloth production and it will produce cloth. England can
import wine from Portugal and Portugal can import cloth from England. Both the
countries have mutual gain from trade as explained below.
Portugal will gain if it can get anything more than 0.88 units of cloth for one unit of
wine. Similarly England will gain if it has to sacrifice anything less than 1.2 units
of cloth. Therefore, any exchange ratio between 0.88 and 1.2 units of cloth for one
unit of wine will bring a gain for both the countries.
Criticisms
The important criticisms against comparative cost theory are:
• Labor is not the only element of cost
• Exchange ratio is not always fixed
• Assumption of full employment and perfect competition are not valid.
• The assumption of free trade is highly unrealistic.
• If one country is very small and the other country is big, the big country
cannot sell its entire surplus to the small country

The Heckscher -Ohlin theorem or Factor Endowment Theory

Eli Heckscher in 1919 originally developed the factor endowment theory. Later it
was refined by his student Bertil Ohlin in 1935. Hence the theory is popularly
known as Heckscher -Ohlin theorem. It is a two - country two - commodity model.
The important assumptions of the model.
1. There is perfect competition in the factor market and product market.
2. Factors of production are perfectly mobile within the country but immobile
between countries.
3. Factors of production are homogeneous.
4. There is full employment.
5. There is free trade between countries.
6. There is no transport cost.
7. Technology remains the same in both countries.
Comparative cost theory of international trade did not explain the reason for
comparative cost differences. The Heckscher - Ohlin theorem tried to explain the
causes of comparative cost differences that exist internationally. According to the
theory, the differences in comparative advantage among nations is mainly due to the
differences in relative factor abundance or factor endowments.
The theorem can be stated as follows. A country will produce and export that
commodity whose production requires the intensive use of the nation’s relatively
abundant and cheap factor and import the commodity whose production requires the
intensive use of relatively scarce and expensive factor; in other words, relatively
labor abundant country will export the relatively labor intensive commodity and
import the relatively capital intensive commodity. In Heckscher Ohlin theory, for
example a country will be considered as capital abundant only if the ratio of capital
to other factors is higher when compared to other countries. This can be explained
with the help of an example of country A and country B.

Country A Supply of labour = 50

Supply of capital= 40
Capital-labour ratio = 0.8

Country B Supply of labour = 16

Supply of capital = 20
Capital-labour ratio = 1.25

In this example, country A has more capital in absolute terms but country B is
endowed with or abundant in capital because the ratio of capital to labour is high in
country B.
Factor price Equalization Theorem.
It is also called Heckscher- Ohlin-Samuelson theorem. It was proved by Paul
Samuelson.
The theorem states that free international trade will equalize factor prices between
countries relatively and absolutely. In a country, international trade increases the
demand for abundant factors because specialization takes place on the basis of this
abundant factor; therefore prices of the abundant factors increase. Similarly, the
demand for the scarce factors decreases and hence their prices also decrease ; thus
when a country export goods containing a large proportion of the relatively
abundant and cheap factors and import goods containing a large proportion of
scarce factors, it may act as substitute for interregional factor movements and lead
to factor price equalization.
Merits of Heckscher-Ohlin theory
1. Heckscher Ohlin theory provides a more satisfactory explanation for foreign trade
2. This theory explained the reason for comparative cost differences between nations
in terms of factor abundance or endowments.
3. This theory highlights the role of relative prices of factors in determining the
trade flow.
4. Heckscher Ohlin theory highlights the impact of trade on product and factor
prices.

Effects of international trade

According to Heckscher - Ohlin theorem, international trade has the following
effects.
1. Equalization of factor prices: Since specialization takes place according to factor
endowments, it equates factor prices between countries.
2. Equalization of commodity prices : International trade leads to movement of
goods from those areas where they are abundant to areas where they are scarce ; this
would equalize the commodity prices.
Balance of payments
Balance of payments is a systematic record of all economic transactions of a nation
with the rest of the world for a specific period of time. Usually time period is taken
as one year. The main purpose of balance of payments is to inform the governments
regarding the international currency position of the nation and to help in the
formulation of policies accordingly. Balance of payments is also useful to banks,
firms and individuals who are directly or indirectly involved in international trade
and finance.
As a summary statement of the transactions among countries, balance of payments
provide details of these transactions under different heads.
Balance of trade and balance of payments
It is meaningful to distinguish between balance of payments and balance of trade.
Balance of trade includes only those transactions which are involved in the
exporting and importing of visible items (goods) . It does not include invisible items
such as various kinds of services ( shipping, banking , insurance), payment of
interest and dividend etc. On the other hand, balance of payments include both
visible and invisible items. Therefore balance of payments gives a better picture of
a country’s external balance.
Components of balance of payments
Balance of payments accounting follows double - entry book - keeping system.
Each transaction will result in a credit entry and debit entry of equal size. Therefore,
balance of payments will always balance.
Usually, international transactions are classified under the following heads:
1. Current account 2. Capital account 3. Unilateral payments account 4. Official
reserve assets account
Current account
Current account consists of two major items ; 1. Merchandise (visible ) exports and
imports 2. Invisible exports and imports.
Merchandise exports and imports include sale of goods abroad .These are credit
items and merchandise imports which includes purchase of goods from abroad are
debit items.
Invisible exports and imports are credit entries and imports are debit entries ;
invisible exports means sale of services like transport, insurance, foreign tourist
expenditure in the home country and interest received on loan and dividend on
investment abroad etc. invisible imports include purchase of services like
drytransport and insurance and payment on foreign loans and foreign investments
etc.
Capital Account: includes short term and long term capital transactions. Capital
inflows are coming as credit entries and capital outflows as debit entries. For
example when a US firm invests 100 million in India there will be an entry under
credit for India and an entry under debit for that country. The three major items
coming under capital account are loans, borrowings and investments.
Unilateral transfer account is one way transfers without any expectation of
anything in return from one country to another country or from one person to
another person. The important items coming under unilateral transfers are:
• Payments or remittances from immigrants to their home country.
• Humanitarian aid
 • Aid by one country to another usually from developed nations to less
developed nations.
• Contribution to charitable institutions.
• Membership payment to international agencies.
• Gift from one country to another. This gift could be from a person business or
government.
The official reserve account
It is the foreign currency and securities held by the government usually by its
central bank and is used to balance the payments from year to year. When there is a
trade surplus, the official reserve increases and when there is a trade deficit it
decreases.
Balance of payments disequilibrium – Deficit
The balance of payment is in disequilibrium when it shows a surplus or deficit ;
when the demand for foreign exchange exceeds the supply of foreign exchange
there is deficit in balance of payments.
Factors responsible for a disequilibrium in balance of payments
The important factors leading to a disequilibrium in balance of payments are:
Economic factors
Political factors
Social factors
Economic factors
The important economic factors which lead to balance of payments disequilibrium
are:
1. Development disequilibrium : Large scale development expenditure may increase
the purchasing power of the people and they demand more important items.
2. Cyclical disequilibrium : When there is boom for prosperity imports may
increase more than exports and it creates a deficit in balance of payments.
3. Secular disequilibrium: In developed countries disposable income and aggregate
demand will be very high . Wages may increase and the production cost also
increases. This may result in high prices. Higher aggregate demand and higher
prices lead to larger imports and deficit in the balance of payments.
Political factors
Political instability in a country will adversely affect the investments in the
domestic country which leads to deficit in balance of payments.
Social factors
Changes in today’s fashion etc may change consumption habits of the people and
this may affect export and import as well as balance of payments.
Correction of disequilibrium or deficit
Balance of payments deficit has to be corrected; the following are the important
measures to correct a balance of payments.
Automatic correction: with the help of demand and supply mechanism the
economy will try to correct the disequilibrium automatically. There will be an
increase in exports and deficits will be corrected.
Deliberate measures:
The three deliberate measures are
Monetary measures
Trade measures
Miscellaneous measures
Monetary measures:
Monetary contraction or expansion
When there is a deficit a contraction of money supply will decrease the purchasing
power of the people and hence the aggregate demand as well as the price level falls.
This reduces the imports. When there is a fall in the price in the domestic economy
it encourages export thus deficit will be corrected
Devaluation: It means a deliberate reduction in the value of a currency in terms of
foreign currency by reducing the official rate at which it is exchanged for another
country's currency. When there is a deficit in the balance of payments, devaluation
of the currency encourages export and discourages import; devaluation makes the
domestic goods cheaper for the foreigners and foreign goods expensive for the
people in the home country.
Exchange control: Through exchange control, the government or the central bank
will have the complete control over the foreign exchange earnings of the country.
Trade measures
Export promotion and import control are the trade measures to correct balance of
payment.
Export promotion
Export can be encouraged by abolishing export duty, giving export subsidy and by
providing facilities for export oriented production.
Import control:
Imports can be discouraged by increasing import duties through import
quotas,import licensing etc
Miscellaneous measures
Miscellaneous measures include encouragement of foreign investment, promotion
of tourism etc.
Devaluation
Devaluation means a deliberate reduction of the value of the domestic currency in
terms of foreign currencies. A country which faces a serious problem of deficit in
the balance of paymen€ts may resort to devaluation. This will encourage their
export and discourage import.
With the help of the devaluation of Indian rupee in 1966 the working of devaluation
can be explained.
Before devaluation the exchange rate was $ 1= Rs 4.76 . Devaluation of the Indian
rupee was 36.5% and it was 57.56 against dollar then the exchange rate became $1
= Rs. 7.5. After devaluation, import became costly. Before devaluation a foreign
commodity which cost $1.00 abroad cost Rs.4.76 in India. But after devaluation
the same commodity cost $1.00 abroad but Rs. 7.5 in India. Thus imported goods
became costlier in India. Similarly export became cheaper after devaluation . Before
devaluation a commodity which cost Rs. 4.76 in India and $1 abroad now cost only
$ 0.64 for the foreigners; this made Indian goods cheaper in the foreign market and
encouraged export.
Limitations of devaluation
The success of devaluation depends on reactions of other countries. If they retaliate
by devaluing their currencies devaluation will not be successful. If prices in the
domestic country increases at the same rate or at a higher rate of devaluation, it will
not increase export or decrease import.
Currency pass-through
Theoretically it is assumed that a given change in exchange rate will bring a
proportionate change in import prices. But in practice, import prices change less
than proportionately, thus weakening the effect of devaluation. The extent to which
the change in exchange rate leads to a change in export and import prices is called
currency pass-through relationship.
Free Trade Versus Protection
Free trade is a trade policy that does not restrict imports or exports. In other words
it refers to the trade that is free from all artificial barriers to trade like tariffs,
exchange control etc. In the case of free trade, the free market idea is applied to
international trade.
Protection is the policy of protecting domestic industries against foreign
competition by means of tariffs, subsidies, import quotas etc . It affects mainly the
imports of a country. Government - levied tariffs are the chief protectionist
measures. They raise the price of imported products making them more expensive
than domestic products.
Arguments for free trade
The important arguments in favor of free trade are:
1. Better utilization of resources: Free trade leads to the most economic utilization
of resources.
2. Division of Labor and specialization: Under free trade, each country will
specialize in the production of those goods in which it has a comparative advantage.
This leads to large scale production, division of labor and efficiency.
3. Efficiency : There is intense competition under free trade and hence inefficient
firms cannot survive. Hence firms try to increase their efficiency.
4. Discourage monopoly practices: Free trade prevents domestic monopolies by
providing internationally available goods at lower prices.
5. Wide variety of goods: Free trade enables the consumers to avail all types of
internationally available goods at cheapest prices.
6. Avoid corruption and red-tapism: Free trade is free from bureaucratic
interferences and hence it avoids corruption and delay in taking trade related
decisions.
7. Economic growth: largescale production and division of labor leads to economic
growth.
Arguments against free trade
1. Threat to domestic industries: Because of free trade imported goods become
available at a cheaper price. Thus an unfair and cut- throat competition develops
between domestic and foreign industries and domestic industries are wiped out in
this process.
2. Harmful commodities: A country may change its consumption habits. Because
of free trade, even harmful commodities like drugs etc enter the domestic market.
3. The unfair- competition argument : It is argued that free trade leads to
competition among unequals. Developing countries cannot fairly compete with the
developed countries because their cost conditions may be different.
4. Degradation of environment: free trade leads to depletion of timber minerals and
other natural resources because of their overexploitation
5. Poor working conditions: Multinational companies may outsource jobs to
emerging developing countries without adequate labor protections; as a result
women and children may involve in factory jobs in substandard conditions.
Arguments in favor of protection
When the domestic industries are threatened by foreign competition, nations may
adopt protectionism to safeguard national interest.
The important arguments in favor of protection are the following.
Infant industry argument: This argument says that when a new industry is
launched it must be protected from foreign competition. Already established
companies will have certain advantages like economies of scale, market power,
experience etc. If an infant industry has to compete with such a foreign competitor,
it is competition between unequals and this will lead to the destruction of the infant
industry. According to protection policy, “ nurse the baby, protect the child and free
the adult”.
Strategic and key industry argument:
It is argued that a country should develop its own strategic and key industries.
Hence they have to protect and develop such industries.
National Defense:
If we depend on other nations for defense , it will be a foolishness because if they
deny it at times when it is most urgent it will be a threat to the security of the
nation. Hence, defense industries should be protected and developed.
Anti dumping:
Through dumping, a foreign company may sell its product at very low prices in the
home country and this may ruin the domestic industries. Once they get a monopoly
over the product they will increase the price and hence it will be harmful in the long
run. By protective measures a government can prevent dumping.
Employment argument:
When imports are restricted through protective measures, production in the home
country is encouraged and it will create more employment opportunities in the
home country.
Size of the home market:
It is argued that protection will enlarge the market for agricultural products because
of the increase in the price of the farm products imported from foreign countries as
well as the increase in the purchasing power of the workers who engage in
industrial sector by way of protection.
Arguments against protection
1. Protection is against the interest of the consumers as it increases the price of
the imported products; further consumers are denied the opportunity for enjoying
variety goods.
2. It discourages competition and hence compromises efficiency.
3. It encourages the growth of domestic monopolies because of the weakening of
foreign competition.
4. Protection discourages innovations.
5. It leads to a wasteful utilization of world resources.
6. Protection may lead to trade wars and international conflicts among nations.
Trade barriers
Trade barriers refer to the government policies and measures which restrict the free
flow of goods between countries. Broadly trade barriers are divided into two
groups – tariff barriers and non tariff barriers.
Tariff barriers
Tariff barriers are duties or taxes imposed by the government of a country on its
imports or exports. Tariff is an important measure of protection. But recently
because of the involvement of WTO, countries are reducing tariffs.
Tariffs can be classified in to the following three categories on the basis of
origin and destination of goods
1. Export duties – these are taxes levied on goods originated in the duty levying
country ( home country )and destined for some other countries.
2. Import duties – these are taxes imposed on goods originated abroad and destined
for the home country which levies duty.
3. Transit duty – these are taxes imposed on goods crossing the borders of a
country. But these goods are originated from and destined for some other countries.
Tariffs can be classified into the following three categories based on the
quantification of tariffs.
1. Specific duties- it is a fixed amount of duty imposed on each unit of the
commodity exported or imported.
2. Ad-valorem duties- these are duties levied as a fixed percentage of the value
of the commodity imported or exported.
3. Compound duties - when specific and add valorem duties are imposed on a
commodity it is known as compound duties.
Tariffs may be classified into the following three categories based on the
application of tariffs between different countries.
1. Single column tariff:
Under this type of tariff system, a uniform tariff is imposed on similar product
irrespective of the country from which they are imported.
2. Double column tariff – in this type, two rates are imposed on some
commodities or all commodities.
3. Triple column tariff – in this system three rates of tariffs general, intermediate
and preferential are levied.
Tariffs can be classified into the following three categories based on the
purpose they serve.
1. Revenue tariff- when revenue raising is the only motive of imposing a tariff,
it is called revenue tariff. Generally this type of tariff rate will be low.
2. Protective tariff – this type of tariff is imposed with an intention to protect
domestic industries. Usually the rates will be high.
3. Countervailing and anti dumping tariffs- countervailing tariffs are imposed on
those commodities which are heavily subsidized by the foreign governments .
When foreign goods are sold in the domestic market at price lower than its
cost of production, anti dumping duties are imposed.
Effects of tariffs
Protective effect, revenue effect,income and employment effect, balance of
payments effect, consumption effect ,competition effect and redistribution effect
are the effects of tariffs on the economy.
Non- Tariff Barriers (NTBs)
Nowadays, non-tariff barriers are gaining popularity. Its impact is more on
developing countries than developed countries. There are different types of NTBs -
voluntary export restraints ,variable levies, multifiber agreement restrictions
1. Voluntary Export Restraints (VER) is a trade restriction on the quantity of a
good that an exporting country is allowed to export to another country. This limit is
self imposed by the exporting country.
2. Administered protection
Administered protection includes a wide range of government actions through
measures like safeguards, health and product standards, customs procedures,
licensing, Environmental Protection laws etc.
Demerits of NTBs
NTBs are less transparent; it is difficult to identify and it is impossible to quantify
its impacts. They are unfair because they do not treat exporters equally.
Quantitative restrictions or Quotas
A quota is a ceiling or limit on the volume of exports or imports.
Important types of import quotas.
1. The tariff or custom quota:
Under this system, import of a commodity up to a specified quantity is allowed to
be duty free or at a special low rate of duty; but imports in excess of this fixed limit
are charged a higher rate of duty.
2. The unilateral quota:
Under this system, a country places an absolute limit on the import of a commodity
during a given period . It is imposed without prior negotiation with foreign
governments.
3. The bilateral quota:
Under this system, quotas are set through negotiation between the importing
country and the exporting country.
4. The mixing quota :
It is a type of regulation which requires producers to utilize a certain proportion of
domestic raw materials along with imported parts to produce finished goods
domestically .It thus sets limits on the proportion of foreign made raw materials to
be imported and used in domestic production.
Import licensing
Under this, importers are required to obtain a license from the proper authorities for
importing any quantity within the specified quotas.
Effects of quotas
The economic effects of quotas include
• price effect
• Consumption effect
• Balance of payments effect
• Protective effects
• Revenue effect
• Redistributive effects
Tariff versus quotas
1. Quota is more effective in regulating trade. When a tariff discourages imports,
quota directly restrict the quantity of imports.
2. Compared to tariff, quotas are more precise and certain in action.
3. Quotas can be more easily imposed and more easily removed.
4. Quota can be used to prevent transmission of recession from foreign countries
to home country.