NATIONAL OPEN UNIVERSITY OF NIGERIA

INTERNATIONAL TRADE AND FINANCE I

ECO 445

SCHOOL OF ARTS AND SOCIAL SCIENCES

COURSE GUIDE

Course Developer:
ATTAH, Bolajoko Olanike
Economics Department
University of Benin
NATIONAL OPEN UNIVERSITY OF NIGERIA
National Open University of Nigeria
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National Open University of Nigeria 2006
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CONTENT
Introduction
Course Content
Course Aims and Objectives
Working through this Course
Course Materials
Study Units
Textbooks and References
Assignment File
Presentation Schedule
Assessment
Tutor-Marked Assignment (TMAs)
Final Examination and Grading
Course Marking Scheme
How To Get The Most From This Course
Tutors and Tutorials
Summary
Introduction
The course International Trade and Finance I (ECO 445) is a first semester core course
which carries two credit units for fourth year level Economics students in the School of
Art and Social Sciences at the National Open University, Nigeria. This coursework will
be useful in your academic pursuit and help to gain in-depth insight into international
trade and finance.
This course guide is built partially on prerequisite knowledge (i.e. introductory part in
macroeconomics), however, its simplicity will make the student assimilate faster and
practice questions at the end of each unit will also prepare the student for the
examination purposes. It suggests some general guidelines for the amount of time
required of users on each unit in order to achieve the course aims and objectives
successfully. It also provides users with some guidance on their tutor marked
assignments (TMAs) as contained herein.
Course Content
The course is made up of seventeen units (five modules) spread across fourteen lecture
hours and covering areas such as basic concepts in international trade, traditional and
modern theories of international trade, international trade and finance policies and
lastly, international finance concepts.
Course Aims and Objectives
The course attempt to explain the concepts and conceptual framework of international
trade and finance, the reasons for international trade, merits and demerits of
international trade, traditional and modern theories of international trade, and
international payment system. Also, the course is prepared in a way in which the users
would easily enhance their previous knowledge.The course aims, is to help users
develop critical thinking skills, learn how to evaluate economic arguments, and
understand the roles of international economic thought in guiding current international
economic policies and debates.
However, the overall aims of the course will be achieved by:
i. Evaluating the concept and conceptual framework of international trade and finance.
ii. Establishing distinction between internal (domestic or local) and international trade.
iii.Understanding the traditional and modern theories of international trade.
iv. Discussing the models of trade and vis-a-vis economic growth.
v. Explaining the international trade policies and payment system
Working through the Course
To successfully complete this course, you are required to read the study units, referenced
books and other materials on the course.
Each unit contains self-assessment exercises called Student Assessment Exercises (SAE).
At some points in the course, you will be required to submit assignments for assessment
purposes. At the end of the course there is a final examination. This course should take
about 10weeks to complete and some components of the course are outlined under the
course material subsection.
Course Material
The major component of the course and what you have to do and how you should
allocate your time to each unit in order to complete the course successfully on time are
listed as follows:
1. Course guide
2. Study unit
3. Textbook
4. Assignment file
5. Presentation schedule
Study Unit
There are 17 units in this course which should be studied carefully and diligently.

Module 1: Introduction to International trade

Unit 1: Meaning of international trade
Unit 2: Basic tools of international trade analysis
Unit 3: Major differences between internal and international trade

Module 2: Major Concepts of International Trade

Unit 1: Basic Concepts of International trade
Unit 2: Concept of Terms of Trade
Unit 3: Balance of Trade and Balance of Payment

Module 3: International Trade Benefits and Dumping

Unit 1: Benefits and Gains from Trade
Unit 2: Concept of Dumping
Unit 3: Trade Control

Module 4: Early Theories in International Trade

Unit 1: Mercantilism
Unit 2: Absolute Advantage trade theory
Unit 3: Comparative Advantage Trade Theory
Module 5: Modern Theory of International Trade
Unit 1: Heckscher-Ohlin Theory
Unit 2: Samuelson’s Factor-Price Equalisation Theorem
Unit 3: Factor Intensity Reversal Analysis

References and Other Resources

Every unit contains a list of references and further reading. Try to get as many as possible
of those textbooks and materials listed. The textbooks and materials are meant to deepen
your knowledge of the course.

Assignment File
There are assignments on this course and you are expected to do all of them by following
the schedule prescribed for them in terms of when to attempt them and submit same for
grading by your tutor. The marks you obtain for these assignments will count toward the
final mark you obtain for this course. Further information on assignments will be found
in the Assignment File itself and later in this Course Guide in the section on Assessment.

There are four assignments in this course. The four course assignments will cover:
Assignment 1 - All TMAs’ question in Units 1 - 3 (in Module 1)
Assignment 2 - All TMAs' question in Units 1 - 3 of Module 2
Assignment 3 - All TMAs' question in Units 1 - 3 of Module 3
Assignment 4 - All TMAs' question in Units 1 - 3 of Module 4
Presentation Schedule
The presentation schedule included in your course materials gives you the important
dates for this year for the completion of tutor-marking assignments and attending
tutorials. Remember, you are required to submit all your assignments by due date. You
should guide against falling behind the schedule.
Assessment
There are two types of assessment of the course. First are the tutor-marked assignments;
second, there is a written examination.

In attempting the assignments, you are expected to apply information, knowledge and
techniques gathered during the course. The assignments must be submitted to your tutor
for formal assessment in accordance with the deadlines stated in the Presentation
Schedule and the Assignments File. The work you submit to your tutor for assessment
will count for 30 % of your total course mark.

At the end of the course, you will need to sit for a final written examination of three
hours duration. This examination will also count for 70% of your total course mark.
Tutor-Marked Assignments (TMAs)
There are four tutor-marked assignments in this course. You will submit all the
assignments. You are enjoined to work all the questions thoroughly. The TMAs
constitute 30% of the total score.

Assignment questions for the units in this course are contained in the Assignment File.
You will be able to complete your assignments from the information and materials
contained in your text books, reading and study units. However, it is desirable that you
demonstrate that you have read and researched more widely than the required minimum.
You should use other references to have a broad viewpoint of the subject and also to give
you a deeper understanding of the subject.

When you have completed each assignment, send it, together with a TMA form, to your
tutor. Make sure that each assignment reaches your tutor on or before the deadline given
in the Presentation File. If for any reason, you cannot complete your work on time,
contact your tutor before the assignment is due to discuss the possibility of an extension.
Extensions will not be granted after the due date unless there are exceptional
circumstances.
Final Examination and Grading
The final examination will be of three hours' duration and have a value of 70% of the
total course grade. The examination will consist of questions which reflect the types of
self-assessment practice exercises and tutor-marked problems you have previously
encountered. All areas of the course will be assessed
Use the time between finishing the last unit and sitting for the examination to revise the
entire course material. You might find it useful to review your self-assessment exercises,
tutor-marked assignments and comments on them before the examination. The final
examination covers information from all parts of the course.
Course Marking Scheme
The table presented below indicate the total marks (100%) allocation.
Assessment Marks
Assignment (Best three assignment out of the four marked) 30%
Final Examination 70%
Total 100%

How to Get the Most from This Course

In distance learning the study units replace the university lecturer. This is one of the great
advantages of distance learning; you can read and work through specially designed study
materials at your own pace and at a time and place that suit you best.
Think of it as reading the lecture instead of listening to a lecturer. In the same way that a
lecturer might set you some reading to do, the study units tell you when to read your
books or other material, and when to embark on discussion with your colleagues. Just as
a lecturer might give you an in-class exercise, your study units provides exercises for you
to do at appropriate points.

Each of the study units follows a common format. The first item is an introduction to the
subject matter of the unit and how a particular unit is integrated with the other units and
the course as a whole. Next is a set of learning objectives. These objectives let you know
what you should be able to do by the time you have completed the unit.
You should use these objectives to guide your study. When you have finished the unit
you must go back and check whether you have achieved the objectives. If you make a
habit of doing this you will significantly improve your chances of passing the course and
getting the best grade.

The main body of the unit guides you through the required reading from other sources.
This will usually be either from your text books or from a readings section. Some units
require you to undertake practical overview of historical events. You will be directed
when you need to embark on discussion and guided through the tasks you must do.
The purpose of the practical overview of some certain historical economic issues are in
twofold. First, it will enhance your understanding of the material in the unit. Second, it
will give you practical experience and skills to evaluate economic arguments, and
understand the roles of history in guiding current economic policies and debates outside
your studies. In any event, most of the critical thinking skills you will develop during
studying are applicable in normal working practice, so it is important that you encounter
them during your studies.

Self-assessments are interspersed throughout the units, and answers are given at the ends
of the units. Working through these tests will help you to achieve the objectives of the
unit and prepare you for the assignments and the examination. You should do each self-
assessment exercises as you come to it in the study unit. Also, ensure to master some
major historical dates and events during the course of studying the material.

The following is a practical strategy for working through the course. If you run into any
trouble, consult your tutor. Remember that your tutor's job is to help you. When you need
help, don't hesitate to call and ask your tutor to provide it.
Read this Course Guide thoroughly.
 Organize a study schedule. Refer to the `Course overview' for more details. Note
the time you are expected to spend on each unit and how the assignments relate to
the units. Important information, e.g. details of your tutorials, and the date of the
first day of the semester is available from study centre. You need to gather
together all this information in one place, such as your dairy or a wall calendar.
Whatever method you choose to use, you should decide on and write in your own
dates for working breach unit.
  Once you have created your own study schedule, do everything you can to stick to
it. The major reason that students fail is that they get behind with their course
work. If you get into difficulties with your schedule, please let your tutor know
before it is too late for help.
 Turn to Unit 1 and read the introduction and the objectives for the unit.
 Assemble the study materials. Information about what you need for a unit is given
in the `Overview' at the beginning of each unit. You will also need both the study
unit you are working on and one of your text books on your desk at the same time.
 Work through the unit. The content of the unit itself has been arranged to provide
a sequence for you to follow. As you work through the unit you will be instructed
to read sections from your text books or other articles. Use the unit to guide your
reading.
 Up-to-date course information will be continuously delivered to you at the study
centre.
 Work before the relevant due date (about 4 weeks before due dates), get the
Assignment File for the next required assignment. Keep in mind that you will
learn a lot by doing the assignments carefully. They have been designed to help
you meet the objectives of the course and, therefore, will help you pass the exam.
Submit all assignments no later than the due date.
 Review the objectives for each study unit to confirm that you have achieved them.
If you feel unsure about any of the objectives, review the study material or consult
your tutor.
 When you are confident that you have achieved a unit's objectives, you can then
start on the next unit. Proceed unit by unit through the course and try to pace your
study so that you keep yourself on schedule.
 When you have submitted an assignment to your tutor for marking do not wait for
it return `before starting on the next units. Keep to your schedule. When the
assignment is returned, pay particular attention to your tutor's comments, both on
the tutor-marked assignment form and also written on the assignment. Consult
your tutor as soon as possible if you have any questions or problems.
 After completing the last unit, review the course and prepare yourself for the final
examination. Check that you have achieved the unit objectives (listed at the
beginning of each unit) and the course objectives (listed in this Course Guide).

Tutors and Tutorials

There are some hours of tutorials (2-hours sessions) provided in support of this course.
You will be notified of the dates, times and location of these tutorials. Together with the
name and phone number of your tutor, as soon as you are allocated a tutorial group.

Your tutor will mark and comment on your assignments, keep a close watch on your
progress and on any difficulties you might encounter, and provide assistance to you
during the course. You must mail your tutor-marked assignments to your tutor well
before the due date (at least two working days are required). They will be marked by your
tutor and returned to you as soon as possible.

Do not hesitate to contact your tutor by telephone, e-mail, or discussion board if you need
help. The following might be circumstances in which you would find help necessary.
Contact your tutor if.
• You do not understand any part of the study units or the assigned readings
• You have difficulty with the self-assessment exercises
• You have a question or problem with an assignment, with your tutor's comments on an
assignment or with the grading of an assignment.

You should try your best to attend the tutorials. This is the only chance to have face to
face contact with your tutor and to ask questions which are answered instantly. You can
raise any problem encountered in the course of your study. To gain the maximum benefit
from course tutorials, prepare a question list before attending them. You will learn a lot
from participating in discussions actively.
Summary
This course, International Trade and Finance (ECO 445), exposes the users to the
rudiments of international trade and finance theory such asthe concepts and conceptual
framework of international trade and finance, the reasons for international trade, merits
and demerits of international trade, traditional and modern theories of international trade,
and international payment system. It equally explains the theory of international trade and
issues closely related to it such as balance of trade and payments, disequilibrium in
balance of payments and the solution to these problems.

On successful completion of this course, you would have developed crucial thinking
skills with the material necessary for efficient and effective discussion of economic issues
and events both theoretically and practically. However, to gain a lot from the course
please try to apply anything you learn in the course to term papers writing in other
economic development courses. We wish you success with the course and hope that you
will find it both interestingly intuitive and courteously functional.
 MODULE ONE
INTRODUCTION TO INTERNATIONAL TRADE

Unit 1: Meaning of international trade

Unit 2: Basic tools of international trade Analysis
Unit 3: Major Differences between Internal and International Trade
UNIT 1: MEANING OF INTERNATIONAL TRADE
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Definitions of International Trade
3.2 Basic Characteristics of International trade
3.3 Importance of International trade
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Readings

1.0 Introduction
This unit is to discuss the meaning of international trade, the characteristics of
international trade and its importance to participating countries. In other words the basic
features that differentiate international trade from other kinds of trade will be fully
explored.
2.0 Objective
At the end of this unit student should be able to
• Define and know the meaning of International Trade
• Understand the basic characteristics of international trade
• Explain the importance of trade among nation
• Compare foreign trade with any other trade

3.0 Main Content

3.1 Definition of International Trade
Arnold Kling (2012), argued that the view of economists tend to differ from those of the
general public on issue concerning international trade. He noted three principal
differences; first, that many non-economists believe it is more advantageous to trade with
other members of one’s nation of ethnic group than with outsiders. Economists see all
form of trade as equally advantageous. Second, many non-economists believe that
exports is better than imports for the economy. Economists believe that all trade is good
for the economy. Third, many non-economists believe that a country balance of trade is
governed by the “competitiveness” of its wage rates, tariffs, and other factors.
Economists believe that the balance of trade is governed by many factors, including the
aforementioned, but also including differences in national saving and investment.
However, international trade can be defined as the exchange of capital, goods and
services across international borders or territories, which could involve the activities of
the government and individual. In most countries, such trade represents a significant
share of gross domestic product (GDP). In summary,international trade can be defined as
trade between two nations or countries, it involves many factors such as foreign exchange
for possibility of importation and exportation of goods and services, language barriers,
transport cost etc.
Self Assessment exercise:
What are the arguments put forth by Arnold Kling as relate to international trade?
3.2 Characteristics of International Trade
There are numbers of salient qualities that international trade involves. These include the
following among others;

i. Human wants and countries’ resources do not totally coincide. Hence, there tends
to be interdependence on a large scale.
ii. Factors endowments in different countries differ
iii. Technological advancement of different countries differs. Some countries are
better placed in one kind of production and some others in some other kinds of
production.
iv. Labour and entrepreneurial skills in different countries.
v. Factors of production are highly immobile between countries. The degree of
immobility of factors like labour and capital is greater between countries than
within a country. Immigration law, citizenship, qualification, etc,. often restrict the
international mobility of labour. According to Harrod, he believes that domestic
trade consists largely of exchange of goods between producers who enjoy similar
standards of life, whereas international trade consists of exchange of goods
between producers enjoying widely different standards.
vi. Heterogeneous Markets; in the international economy, world markets lack
homogeneity on account of differences in climate, language, preferences, habit,
customs, weights and measures, etc. The behaviour of international buyers in each
case would therefore, be different.
vii. Different National Groups: International trade takes place between differently
cohered groups. The socio-economic environment differs greatly among different
nations.
viii. Different Political Units: International trade is a phenomenon which occurs among
different political units.
ix. Different National Policies and Government Intervention: Economic and political
policies differ from one country to another. Policies pertaining to trade, commerce,
export and import, taxation, etc., also differ widely among countries though they
are more or less uniform within the country. Tariff policy, import quota system,
subsidies and other controls adopted by the governments interfere with the course
of normal trade
x. between one country and another.
xi. Different currencies: Another notable feature of international trade is that it
involves the use of different types of currencies. So each country has its own
policy in regard to exchange rates and foreign exchange.

Self Assessment exercise: Give a detail explanation on the features of international

trade.
3.3 Importance of international trade

Some importance of International Trade are as follows:

1) International trade enables the full utilization of resources. Most of the time
underdeveloped countries do not use their mineral resources efficiently; they export
their raw materials to developed countries where the same are needed for the
production of other goods.

2) International trade make trading partners gets goods cheaper than otherwise.
Because every country produces those goods in the production of which it has less
comparative cost.

3) By virtue of International trade consumers gets an opportunity to consume a large

variety of goods produced by different countries and this improves the quality of life.

4) International trade enables every country to dispose off their surplus production.
Some countries produce more than their own requirement. They sell this surplus
production in other countries and avoid the occurrence of deflationary pressures in the
domestic economy.

5) International trade encourages countries to compete with each other in the

production of different kinds of goods at low cost of production. Competitiveness
stimulates productivity.

6) It widens the extent of market. Every country makes an attempt to produce

different goods in large quantity. This induces production on large scale and thereby
 generates economies of scale.

7) International trade stimulates the spirit of competition among the entrepreneurs.

New techniques of production are devised to produce quality goods at low cost.
Advancement of technology is the key to economic development.

8) International trade promotes mutual cooperation among different countries. It

creates an atmosphere of goodwill and friendship among the trading countries.Human
wants and countries’ resources do not totally coincide. Hence, there tends to be
interdependence on a large scale.

Self Assessment exercise:International trade tends to bring about interdependence on a

large scale. Discuss
4.0Conclusion
We conclude that the concept of international trade is a vital trade for all countries both
developed and developing countries because of its importance for the growth and
development of every nation and its citizens.

5.0 Summary
In this study unit we attempt to explore different definitions of the concept of
international trade and finance, the main features of international trade and the
importance of international trade to all countries.
6.0Tutor-Marked Assignment
a) Define the term international trade
b) There are some salient features of international trade that makes it different from
other trade. What are these characteristics?
c) Discuss how international trade is important to your country.
7.0 References/Further Readings
Arnold Kling (2012); The Coincise Encyclopaedia of Economics, International Trade
Library of Economy Liberty.

Frederic S. Mishkin, (2012); The Economics of Money, Banking and Financial Markets,
10th edition, Pearson.

Jhingan M.L, (2010); International Economics, 6th edition, Vrinda Publications (P)
Ltd. Delhi, India
Jhingan M.L, (2010); Macroeconomics Theory, 12th edition, Vrinda Publications (P)
Ltd. Delhi, India

Krugman Obstfeld, (1975); International Economics Theory and Policy, 8th edition
Pearson International edition,.

Olasupo Akano (1995); International trade theory and evidence, Rebonik publication Ltd,
lagos,
UNIT 2: BASIC TOOLS OF INTERNATIONAL TRADE ANALYSIS
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Graphical Tools of Analysis
3.2 Mathematical or Algebraic Tools of Analysis
3.3 Tabular Tools of International Trade Analysis
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Readings

1.0 Introduction
This unit will looked at the different tools that can be used for the analysis and
explanation of international trade, it considered in details the graphical, mathematical and
the tabular tools of analysis of international trade.
2.0Objective
At the end of this unit student should be able to
• Know how to use graph to explain the concepts of International Trade
• Understand mathematical or algebraic workings involved in the analysis of
international trade
• Understand the tabular analysis of international trade
3.0 Main Content

3.1 Graphical Tools of Analysis

The Graphical illustrative Tool:These include diagrammatic illustration and uses of

curves. They are generally used to explain concept in international trade and finance, and
economics in general, these include the following among others;

i. The Production Possibility Curve

A production possibility curve represents the supply side in international trade
equilibrium. It shows the various alternative combinations of the two commodities that a
country can produce most efficiently by fully utilizing its factors of production with the
available technology. It is based on the concept of opportunity costs. The slope of
production possibility curve measures the amount of one commodity that a country must
 give up in order to get an additional unit of the second commodity. In other words, the
slope of production possibility curves whether a straight line or a curvature, is negative.
The slope of the production possibility curve depends on cost conditions operating in an
economy. Under constant opportunity costs, the production curve is a straight line,
shown as PB in Fig. 1. The production possibility curve under increasing opportunity

costs is concave to the origin, shown as AA in Fig. 2. Under decreasing opportunity

costs, the production possibility curve is convex to the origin, shown as AA1 in Fig. 3.
The production possibility curve, as a tool of analysis has been used by Haberler as a
refinement to the classical theory of international trade. But the production possibility
curve does not tell what will, in fact, be produced. It merely sets out what the
possibilities are. More information is needed for this purpose on the demand side.

ii. The Offer Curve

Another important tool of analysis in international economics is the offer curve, also
known as the reciprocal demand curve developed by Mill, Edgeworth, Marshall and
Meade. The offer curve of a country determines the relative commodity price at which
trade takes place. It shows the various quantities of its exportable commodity a country
is willing to exchange for an importable commodity at various international prices.

Fig 1.2.2: The Offer Curve

In order to determine the trade equilibrium at given international prices. This point is
achieved at the point where the two offer curves intersect, this point will determine the
quantities of exports and imports of each commodity offered at international prices by
the two countries. The offer curves OA and OB intersect at point E2 (= E2). At the
international price line P3 (=P2), country A offers OD of its exports of Y in exchange for
OD1 of imports of X from country B. Similarly, country B offers OD1of its exports of X
in exchange for OD import of Y from country A. at any point other than E2, say E1 on
the price line OP2, country A would be willing to exchange OG of its commodity Y for a
lesser amount GE1 of X country B. similarly, if B is at point E on the international price
line OP1, it would be willing to accept much less quantity G1E of commodity Y form
country A in exchange for OG1 of X in country B. Thus, neither point E1 nor point E on
the international price line OP2 and OP1 can be one of equilibrium, because the terms of
trade implied by the ray from the origin of each point do not suffice to clear the market”
Hence, the point E2 (= E2 ) where the offer curve OA and OB of the two countries
intersect will be the equilibrium point.

iii. The Edgeworth Box

The box diagram is another analytical tool used from the supply side in the
international trade theory. It permits us to study the inter-relationships between
production functions and total numbers of factors of production and to derive optimal
factors inputs and outputs.

Fig 1.2.3: The Edgeworth Box(Box Diagram)

The starting point is the combination of two isoquant diagrams representing two
commodities (A and B) which may be joined together to form a box diagram, as shown
above, the vertical axis measures capital and the horizontal axis labour from the origin
Oa which represents commodity A. the isoquants aa, a1a1 and a2a2 are the isoquants of this
commodity. They are drawn on the assumption of the homogenous production function
of the degree one. Accordingly, the isoquants are so drawn that the isoquant a1a1 is twice
as far as from the origin Ob as the isoquant aa, and a2a2 is three times as far as from the
origin as aa. Similarly, the origin Ob relates to commodity B and its isoquants are
represented by bb, b1b1 and b2b2. The assumption of homogenous production of degree
one equally holds in this case. Any point on the box diagram represents four things: it
measures from the lower left-hand corner (Oa) the amounts of capital and labour used to
produce that commodity A, and from the upper right-hand corner (Ob) the amounts of
capital and labour used in the production of the other commodity B. Any point in the box
diagram, for instance, S where the isoquants a1a1 and bb intersect, represents a certain
combination of the two commodities with the help of the two input combinations. To
produce S units of commodity A, Oa of capital and OaD of labour are needed; and to
produce S units of commodity B, ObC1 of capital and ObD1 of labour are required. These
combinations of the two inputs are essential because full employment of factors is
assumed. But S is not a point of economically efficient production of the two
commodities A and B or optimum allocation of the two named factors. This is because at
point S the ratio between the marginal productivities is different in the production of both
commodities as indicated by the different slopes of the two isoquants. Also at point S. the
tangent t1 on the isoquant a1a1 is much steeper than the tangent t on the isoquant bb, this
imply that labour is relatively more productive in making commodity A than B, whereas
the opposite is true of capital. Therefore, labour should be shifted from B production to A
production, and capital from A production to B production.
If we move along the isoquant a1a1 toward Q, the production of A remains unchanged
because we are still on the isoquant a1a1. But the production of B has increased as we
have moved to a higher isoquant b1b1 from bb. This has been possible due to the shifting
of CE of capital from the production of A to B and point D1F1 (= DF) of labour from the
production of B to A. Thus, to produce Q units of A, ObF1 of labour are used. However,
at point Q which is the “efficient locus” or the point of economically efficient production
for both A and B, because at this point the ratio between the marginal productivities in
the production of A and B are equalized, as shown by the tangent t2t2 that passes through
the locus of isoquant a1a1 and b1b1. Similarly, point P and R are economically efficient
production points of the commodities. This is because the isoquants of the two
commodities have opposite curvatures and each curve is tangent to the other at a single
point, and the tangent point passing through each point is parallel to the other, i.e., t1t1 is
parallel to t2t2, and to t3t3.
Self Assessment exercise: How can the edgeworth box be useful in the analysis of
international trade.
3.2 Mathematical or Algebraic Tools of Analysis

Equationsor mathematical functions are often used as illustrative tools of analysis in

international trade and finance and in economics in general. The estimation of exchange
rates, term of trade, and calculation of balance of payment and trade etc are done base on
this illustrative tool of analysis. For instance, the estimation (calculation) of various types
of terms of trade;

i. Commodity terms of trade

𝑃𝑃𝑃𝑃1 𝑃𝑃𝑃𝑃 1
Tc =
𝑃𝑃𝑃𝑃0 𝑃𝑃𝑃𝑃 0

Where the subscripts 0 and 1 indicate the base and end periods.

Taking 2001 as the base year and expressing Nigeria’s both export prices and import
prices as 100, if we find that by the end of 2010 its index of export prices had fallen to
90 and the index of import prices had risen to 110. The terms of trade had changed and
will be calculated as follows;
90 110
Tc = / = 81.82
100 100

ii. Gross barter terms of trade

𝑄𝑄𝑄𝑄 1 𝑄𝑄𝑄𝑄1
Tg =
𝑄𝑄𝑄𝑄 0 𝑄𝑄𝑄𝑄0

Taking 2001 as the base year and expressing Nigeria’s both quantities of imports and
exports as 100, if we find that the index of quantity imports had risen to 160 ad that of
quantity exports to 120 in 2010, then the gross barter of trade had changed as follows.
160 120
Tg = = 133.33
100 100

iii. Income terms of Trade

𝑃𝑃𝑃𝑃
Ty = Tc.Qx = Px.Qx = Index of Export Prices × Export Quantity �𝑤𝑤ℎ𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 = � 𝑃𝑃𝑃𝑃 �
Pm Index of Import Prices

i.e. Ty is the income terms of trade; Tc the commodity terms of trade; and Qx the export
volume index. This index could be calculated by dividing the index of the value of
exports by an index of the price of imports, and it is called the “Export Gain from Trade
Index”.

Taking 2001 as the base year, if

Px = 140, Pm = 70 and Qx = 80 in 2010, then
140×80
PY = = 160
70

It implies that there is improvement in terms of trade by 60 per cent in 2001 as compared
with 1991.

If in 2001, Px = 80, Pm = 160 and Qx = 120,

Then,
80×120
Py = = 60
160

It implies that the income terms of trade have deteriorated by 40 per cent in 2010 as
compared with 20.10
Self Assessment exercise: Differentiate between the mathematical illustration of the
commodity terms of trade and gross barter terms of trade.

3.3 Tabular Tools of International Trade Analysis

Tabular illustration just like others table are often used to explain situation or analytical
reason for better understanding of the concept. For instance analytical table could be used
to explain the gains from trade and more, such as Adam Smith Absolute Cost Advantage
as illustrated below;

Table 1.2.1: Absolute Difference in Cost

Country Commodity X Commodity Y
A 10 5
B 5 10
From the table above there are two countries (A and B) and two commodities (X and Y),
each country produce certain quantity of the two commodities; for country A, (X,Y)=
(10,5) while country B, (X,Y) = (5,10). Country A has absolute cost advantage in
production of commodity X, but country B has least cost advantage of producing
commodity Y, therefore specialised in its production. The analytical table below explain
the specialisation procedure in order to maximise the available global resources and gains
from trade.
Table 1.2.2: Tabular Analytical Representation of Gains from Trade
Commodity Production Production Gains from
before Trade after Trade Trade
Country (1) (2) ( 2 -1 )
 X Y X Y X Y
A 10 5 20 - +10 -5
B 5 10 - 20 -5 +10
Total production 15 15 20 20 +5 +5

Self Assessment exercise:

Explain any gains from trade you know using the tabular analysis of international trade
4.0 Conclusion
We established the fact that understanding the concept and theory of international trade
and finance largely depend on understanding the basic tools of analysis in international
trade in particular and economics thought in general.
.
5.0 Summary
This unit explain analytical tools in international trade and finance and reiterate that
understanding the analytical tools will aid the understanding the concept and theory of
international trade. These analytical tools refer to the basic tools of analysing
international trade which include graphs, equations or mathematical illustration and
tabular illustration.

6.0 Tutor-Marked Assignment

a) Enumerate and explain various tools of analysis in international trade and finance
b) Write short note on any three of the basic tools analysed above.
7.0 References/Further Readings
Amacher, R. & Ulbrich, H. (1986); Principles of Economics, South Western Publications
Co. Cincinnafi, Oliso.

Arnold Kling (2012); the Coincise encyclopaedia of economics, international trade

library of economy liberty.

Attah B.O, Bakare-Aremu, T.A. & Daisi, O.R., (2011); Anatomy of Economics
Principles, Q&A (Macroeconomics), Raamson Printing Press, Oke-Afa, Isolo, Lagos,
Nigeria

Frederic S. Mishkin, (2012); The Economics of Money, Banking and Financial Markets,
10th edition, Pearson.

Jhingan M.L, (2010); International Economics, 6th edition, Vrinda Publications (P)
Ltd. Delhi, India
Jhingan M.L, (2010); Macroeconomics Theory, 12th edition, Vrinda Publications (P)
Ltd. Delhi, India

Krugman Obstfeld, (1975); International Economics Theory and Policy, 8th edition
Pearson International edition,.
 UNIT 3: DIFFERENCE BETWEEN INTERNAL AND INTERNATIONAL
TRADE
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 The concept of Internal Trade
3.2 Major differences between Internal and International Trade
3.3 Merits and Demerits of International Trade
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Readings

1.0 Introduction

This unit is to discuss the concepts of internal trade, it distinguish between internal (i.e.
domestic) trade and international (foreign) trade. It further discusses the advantages and
disadvantages associated with international trade.
2.0Objective
At the end of this unit student should be able to
• Explain the meaning of internal trade
• Distinguish between internal trade and international trade
• Understand the merits and demerits of international trade
3.0 Main Content

3.1 The Concepts of Internal Trade

Internal trade, also known as Domestic trade or home trade is the exchange of domestic
goods within the boundaries of a country. This may be sub-divided into two categories,
wholesale and retail. Wholesale trade is concerned with buying goods from
manufacturers or dealers or producers in large quantities and selling them in smaller
quantities to others who may be retailers or even consumers. Wholesale trade is
undertaken by wholesale merchants or wholesale commission agents.

Retail trade is concerned with the sale of goods in small quantities to consumers. This
type of trade is taken care of by retailers. In actual practice, however, manufacturers and
wholesalers may also undertake retail distribution of goods to bypass the intermediary
retailer, by which they earn higher profits.
The importance or role of domestic trade in a country is that it facilitates exchange of
goods within the country. By doing this it also makes sure that factors of production get
to the right places so that the economy of the country can grow. By allowing different
types of goods and services to reach all parts of the country it improves the standard of
living of the residents of the country as well as the employment rate of the country. And
it helps the growth of an industry by ensuring the availability of raw materials.

Traders from outside the country will have to come in contact with internal traders,
because it is not easy to come directly into another country and get the required products.

Wholesale trade

Wholesalers play a major role in working of domestic trade. One could even say that it is
the backbone of the domestic market. A wholesaler is one who is directly in contact with
the manufacturers but in indirect contact with the consumers. A wholesaler generally
deals with one type of industry. e.g. machinery, textile, stationery. A wholesaler is not
only into selling of products as it is also involved in packaging, advertising, grading, and
market research. They have their own warehouse which saves the manufacturers from
bothering about storage. They normally get cash payments from retailers and sometimes
consumers themselves and give advance payments which benefit the manufacturers. They
sell in smaller quantities to retailers, which refrains the retailers from requiring storage
space. They allow credit facilities to retailers at times.

Retail trade

A retailer is normally the final seller of a product. It makes its purchases from
wholesalers and sales are made to the customers directly. Retailers do not particularly
have to be from one industry i.e. they can trade in a variety of products at the same time.
It generally has purchases made by credit and sales made in cash. Sales as compared to
wholesalers are made in small quantities.

Self Assessment exercise:

Wholesaler plays a major role in the working of internal trade. Discuss

3.2Major Difference betweenInternal and International Trade

A controversy has been going on among economists whether there is any difference
between internal or domestic trade and international or foreign trade. The classical
economists held that there were certain fundamental differences between internal trade
and international trade. Accordingly, they propounded a separate theory of international
trade which is known as the Theory of Comparative Costs. But modern economists
likeBertil Ohlin and Haberler contest this view and opined that the differences between
 internal and international trade are of degree rather than of kind. The following are the
major differences between domestic trade and international trade:

1. Factor Mobility: Labour and capital as factor of production do not move freely from
one country to another as they do within the same country. Thus labour and capital are
regarded as immobile between countries while they are perfectly mobile within a
country. Adam Smith said “Man is of all forms of luggage, the most difficult to
transport”. Differences in cost of production cannot be removed by moving and
money. The result is the movement of goodson the contrary, between regions within
the same political boundaries; people distribute themselves more or less according to
the opportunities. Real wages and standard of living tend to seek a common level
though they are not wholly uniform as between nationals, these differences continue
to persist and check population movements. Capital also does not move freely from
one country to another country.

2. Different Currencies: Each country has a different currency. Buying and selling
between nations give rise to complications absent in internal trade. This hampers
smooth flow of trade as between one country and another country. A large number of
foreign exchange problems arise in number of foreign trade which are non-existent in
internal trade.

3. Different National Policies: Different needs lead countries to pursue divergent

national policies and not only with respect to foreign exchange rates. National
Policies differ in a wide range of domestic matters affecting international economic
relations, wages, prices, competition, investment, business regulation etc and often
involve interference directly in international economic intercourse in tarrifs, exchange
controls, non-tariff barriers and the like.

4. Different Political Circumstances: Mostly countries differ in political

circumstances. In internal trade, trade takes place among same people. But
international trade takes place among people of different cultures, habits and
languages. These cultural distinctions between markets, important in the absence of
different national measures have led political scientists to take look at the nature of
countries.

5. Difference in National Resources: Different countries are endowed with different

type of natural resources. They tend to specialise, in the production of those
commodities in which they are richly endowed and trade them with others where such
resources are scare.

6. Geographical and climatic differences:Every country cannot produce all

commodities due to geographical and climatic conditions, except at possibly
 prohibitive costs. Countries having climatic and geographical advantage specialise in
the production of particular commodities and trade them with others.

7. Different Markets: International markets are different in various aspects. Even the
system of weights and measures and pattern and styles in machinery and equipment
differ from country to country. Goods which are traded within regions may not sold in
other countries. This is why in great many cases products to be sold in foreign
countries are especially designed to confirm to the national characteristics of that
country.

8. Problem of Balance of Payments: The problem of balance of payments is perpetual

in international trade while regions within a country have no such problem.

9. Restrictions on Trade: Trade between different countries is mostly not free. There
are restrictions imposed by custom duties, exchange restrictions, fixed quotas or other
tariff barriers.

10. Ignorance: Differences in culture, language and religion stand in the way of free
communication between different countries.

11. Transport and Insurance Costs: The cost of transport and insurance also check the
free international trade. The greater the distance between the two countries the greater
the cost and insurance.

Self Assessment exercise:

Discuss the differences between internal and international trade?
3.4Merits and Demerits of International Trade
Merits of International Trade
The main merits of international trade to a country are as follows:

i.Boosts Domestic Competitiveness

Exporting or importing your products provides a good chance to increase your
competitiveness within the domestic markets. Once you are to acquire imported
commodities at similar or even lower costs as compared to the ones you acquire from the
domestic market and the other way around, then you will certainly gain profits which will
boost the level of your competence.

ii.Increase in profit and Sales

Once you are able to make exports from your locality or imports in same or high quality
products on the better profit margin, it is possible then for the levels of your sales to
increase. And with this, you get the chance to eventually increase your profits.

iii. Economy in the Use of Productive Resources:

Each country tries to produce those goods in which it is best suited. As the resources of
each country are fully exploited, there is thus a great economy in the use of productive
resources.

iv. Wider Range of Commodities:

International trade makes it possible for each country to enjoy wider range of
commodities than what is otherwise open to it. The commodities which can be produced
at home at relatively higher cost can be brought from the cheaper market from abroad and
the resources of the country thus saved can be better employed for the production of other
commodities in which it iscomparatively better fitted.

v. Scarcity of Commodities:
If at any time there is shortage of food or scarcity of other essential commodities in the
country, they can be easily imported from other countries and thus the country can be
saved from shortage of commodities and low standard of living.

vi. Promotes Competition:

International trade promotes competition among different countries. The producers in
home country, being afraid of the foreign competition, keep the prices of their products a
reasonable level.

vii. Speedy Industrialization:

International trade enables a backward country to acquire skill, machinery; and other
capital equipment from industrially advanced countries for speeding up industrialization.

viii. Fall of Prices:

A country can export her surplus products to a country which is in need of them. The
domestic prices are, thus, prevented from falling.

ix. Extension of Means of Transport:

When goods are exchanged from one county to another, it leads to an extension of the
means of communication and transport.

x. Economic Inter-Dependence:
International trade offers facilities to the citizens of every country tocome in contact with
one another. |t makes them realize that no country in the world is self-sufficient. It thus
promotes peace and goodwill among nations.
Disadvantages of International Trade

International trade has its own demerits/disadvantages; these in brief are as follows:

i. Exhaustion of Resources:
In order to earn present export advantages a country may exploit her limited natural
resources beyond proper limits. This may lead to exhaustion of essential material
resources like iron, coal, oil, etc. The future generation thus stands at a disadvantage.

ii. Effect on Domestic Industries:

If no restrictions are placed on the foreign trade, it may ruin thedomestic industries and
cause widespread distress among the people.

iii. Effect on Consumption Habits:

Sometimes it so happens that the traders in order to make profits import commodities
which are very harmful and injurious to the people For instance, if opium, wine, etc., are
imported, it will adversely affect the health and morale of the people.

iv. Times of Emergency:

If each country specializes in the production of those commodities in which it has
comparative advantage over other countries, it may prove very dangerous rather fatal
during times of
i. Long Term Process
Exports from your local, or some other productive opportunities in import export
business, demand lots of time so as to be converted. So, you have to be very patient in
order to gradually achieve your desired goals. In addition to this, it requires huge time
investment for the business to produce strategic partnerships with various parties inside
the channel.

ii. Additional Licensing And Other Taxes, Regulations, Etc

Plans for import export business should not just be created after taxes, understating
licensing and other relevant country regulations in which you are planning to have your
audiences targeted.

Self Assessment exercise:

Does the merits of international trade outweigh its demerits. Discuss
4.0 Conclusion
We conclude that the concept of international trade has a diverse view and that there
isrelationship as well as dissimilarity between internal and international trade. We equally
established the fact that understanding the concept and theory of international trade and
finance the advantages and disadvantages must be considered.
5.0 Summary
In this study unit we attempt to explore differences between internal and international
trade. This unit further explain the merits and demerits of international trade to any
country.
6.0 Tutor-Marked Assignment
a) Define the term internal trade in relation to international trade
b) Differentiate between internal trade and international trade
c) Evaluate the similarities and dissimilarities between domestic and foreign trade.
d) What are the rewards of international trade to your country?
e) Discuss the disadvantages of international trade
7.0 References/Further Readings
Arnold Kling (2012); the coincise encyclopaedia of economics, international trade library
of economy liberty.

Attah B.O, Bakare-Aremu, T.A. & Daisi, O.R., (2011); Anatomy of Economics
Principles, Q&A (Macroeconomics), Raamson Printing Press, Oke-Afa, Isolo, Lagos,
Nigeria

Jhingan M.L, (2010); International Economics, 6th edition, Vrinda Publications (P)
Ltd. Delhi, India

Krugman Obstfeld, (1975); International Economics Theory and Policy, 8th edition
Pearson International edition,.

Olasupo Akano (1995); International trade theory and evidence, Rebonik publication Ltd,
lagos,
 MODULE TWO
MAJOR CONCEPT OF INTERNATIONAL TRADE

Unit 1: Basic concepts of International Trade

Unit 2: Concept of Terms of Trade
Unit 3: Balance of Trade and Balance of Payment

UNIT 1: BASIC CONCEPTS OF INTERNATIONAL TRADE

CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 The concept of Export, Import and Entre-port
3.2 Relationship between Export and Import
3.3 Importance of Import and Export
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Readings

1.0 Introduction
Export is the term used to selling of products or service from any other country while
import is the activity of buying the same from other countries therefore, this unit
introduces the students to components of both international and internal trade such as
import, export, entre-port and the likes. In the same vein, interrelationship that exists
among all these concepts of international trade will be discussed.
2.0 Objective
At the end of this unit student should be able to
• Define and know the meaning of export and import
• Understand the meaning of entre-port
• Explain the link between export and import
• Understand the importance of import and export to an economy.

3.0 Main Content

3.1 The Concepts of Export, Import and Entre-port
Export Defined: The term export means shipping in the goods and services out of the
jurisdiction of a country. The seller of such goods and services is referred to as an
exporter and is based in the country of export whereas the overseas based buyer is
referred to as an importer in international trade. Export refers to selling goods and
services produced in the home country to other markets. However, export of commercial
quantities of goods normally requires involvement of the customs authorities in both the
country of export and country of import.
Import Defined:An import is a good or service brought into one country from another.
The word ”import” is derived from the word “port” since goods are often shipped via
boat to foreign countries. Along with exports, imports form the backbone of international
trade; the higher the value of imports entering a country, compared to the value of
exports, the more negative that country‘s balance of trade becomes. Moreover, countries
are most likely to import goods that domestic industries cannot produce as efficiently or
cheaply but may also import raw materials or commodities that are not available within
its borders. For example, many countries have to import oil because they cannot produce
it domestically or cannot produce enough of it to meet demand. Free agreements and
tariff schedules often dictate what goods and materials are less expensive to import.

Entre-port Defined:an entre-port or trans-shipment port is a port, city or trading post

where mechanised may be imported, stored or traded, usually to be exported again.
Ordinarily, when goods are imported and later re-exported it is termed entrepot.

Self Assessment exercise:

Discuss the linkage between export and import.
3.2 Relationship between Export and Import

Import and export are terms that are commonly heard in international trade and these are
activities that are carried out by all countries of the world. In general, import refers to an
item coming inside a country from any other country while export refers to an item going
out of the country to any other country of the world. Since no country in the world is self
sufficient, all countries both import as well as export.

If a country is rich in a particular ore as it has natural reserves of that ore in the form of
mines, the country can export that ore to other countries of the world. This is particularly
true of oil producing countries that are exporters of crude oil. However, all such countries
are dependent on other countries for many other products and services which is why they
need to import such items from other countries of the world.

Exports earn money for a country, while imports mean expenses. For example, India is a
country that has a huge number of qualified manpower in the IT sector. This manpower
exports its services to companies doing business in other countries thus earning foreign
currency for India. On the other hand, India is dependent for oil and arms on other
countries and needs to import them for its energy requirements as well as its army. It can
spend the foreign currency it earns through exports to import goods and services it is
deficient in. This is the basic concept behind exports and imports.

It is the endeavour of all countries of the world to achieve parity in their exports and
imports. But in reality it is never so and this is where balance of payment creeps in. In an
ideal situation, where exports equal imports, a country can utilize the money earned
through exports to import goods and services it requires.

However, if a company is an exporter, it does not mean it cannot be an importer. Today

there is so much of interdependency in the world that companies and nations prefer to
import items that they cannot manufacture or which prove to be costlier if they try to
produce themselves. In fact there are companies that specialize in exporting and
importing and can arrange goods for any company from a foreign country on a short
notice as it has a well developed liaising network.

The level of import directly depends on the exchange rate of local currency. If the local
currency is strong which mean that you buy more foreign currency and at the same time
more foreign goods, the import level will increase. If your local currency is weak, then
the import level decreases.

There are several reasons, why companies decide to export their output. First, they may
want to enter geographically new markets and thus expand and internationalize. Second,
it is possible that by exporting, companies are meeting the demand of those who live
abroad because there is no domestic demand for their products or services. Export is also
a great way to diminish supply surplus and thus make production more efficient.

The level of export is strictly connected with the exchange rate of local currency. If it is
weak which means that someone with strong foreign currency may buy more of your
domestic currency and at the same time your domestic goods, then the export level
increases. If your local currency is strong, then the export level decreases.

Self Assessment exercise:

Both exports and imports are essential for the development of any country as no nation is
self sufficient. Discuss

3.3 Importance of Import and Export

Exporting and importing are important because they help to grow the national economies
and expand the global market. Every country is endowed with certain advantages in
resources and skills. For example, some countries are rich natural resources, such as
timber, fossil fuel, fertile soil or precious metals and minerals, while other countries have
shortages of many of these resources. Additionally, some countries have highly
developed infrastructures, educational systems and capital markets that permit them to
engage in complex manufacturing and technological innovations, while many countries
do not.

Imports are important for businesses and individual consumers. Countries often need to
import goods that are either not readily available domestically or are available cheaper
overseas. Individual consumers also benefit from the locally produced products with
imported components as well as other products that are imported into the country. Often
times, imported products provide a better price or more choices to consumers, which
helps their standard of living.

Countries want to be net exporters rather than net importers. Importing is not necessarily
a bad thing because it gives us access to important resources and product not otherwise
available or at a cheaper cost. However, just like eating too much candy, it can have bad
consequences. If you import more than you export, more money is leaving the country
than is coming in through export sales.

On the other hand, the more a country exports, the more domestic economic activity is
occurring. More exports mean more production, jobs and revenue. If a country is a net
exporter, it gross domestic product increases, which is the total value of the finished
goods and services it produces in a given period of time. In other words, net export
increases the wealth of a country.

Self Assessment exercise:

In your own opinion why is export and import essential for economic growth?
4.0 Conclusion

Both import and export are two main activities of a country's international trade. Import
appears, when domestic companies buy goods abroad and bring them to a domestic
country for sale. Export appears when the domestic companies sell their products or
services abroad.

5.0 Summary

The concepts of import, export and entre-port were analysed for clear understanding of
learners. Both export and import are main activities of national trade. If export increases
import than we have trade surplus, if opposite, than we have trade deficit.
6.0 Tutor-Marked Assignment
a) Examine the concept of Import and Export
b) Differentiate among these three concepts of international trade; import, export and
entre-port.
c) Enumerate and explain any three importance of import and export
7.0 References/Further Readings
Amacher, R & Ulbrich, H, (1986); Principles of Economics, South Western
Publications Co. Cincinnafi, Oliso.

Arnold Kling (2012) ; the coincise encyclopaedia of economics, international trade

library of economy liberty.

Attah B.O, Bakare, T.A. & Daisi, O.R., (2011); Anatomy of Economics Principles,
Q&A (Macroeconomics), Raamson Printing Press, Oke-Afa, Isolo, Lagos, Nigeria

Frederic S. Mishkin, (2012); The Economics of Money, Banking and Financial

Markets, 10th edition, Pearson.

Jhingan M.L, (2010); International Economics, 6th edition, Vrinda Publications (P)
Ltd. Delhi, India

Jhingan M.L, (2010); Macroeconomics Theory, 12th edition, Vrinda Publications (P)
Ltd. Delhi, India

Krugman Obstfeld, (1975); International Economics Theory and Policy, 8th edition
Pearson International edition,.
UNIT 2: CONCEPTS OF TERMS OF TRADE
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 The concept of Commodity or Net Barter Terms of Trade and Gross Barter
Terms of Trade
3.2 Income Terms of Trade
3.3 Single Factoral Terms of Trade and Double Factoral Terms of Trade
3.4 Real Cost Terms of Trade and Utility Terms of Trade.
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Readings

1.0 Introduction

Terms of trade refer to the rate at which the goods of one country are exchange for the
goods of another country. In other words, it is a measure of the purchasing power of
exports of a country in terms of its imports, and also expressed as the relation between
export prices and import prices of its goods. When the export prices of a country rise
relatively to its import prices, its terms of trade is said to have improved. The country
gains from trade if it can have a larger quantity of imports in exchange for a given
quantity of exports. Better still, when its import prices rise relatively to its exports prices,
its terms of trade is said to have worsened. The country’s gain from trade is reduced
because it can have a smaller quantity of imports in exchange for a given quantity of
exports than before.
2.0 Objective
At the end of this unit student should be able to

• Define and know the meaning between commodity barter and gross barter
terms of trade
• Understand the concept of income terms of trade
• Know the difference between single factoral terms of trade and double factoral
terms of trade
• Compare real cost term of trade to utility terms of trade
3.0 Main Content
3.1 Commodity or Net Barter Terms of Trade and Gross Barter Terms of Trade

Commodity or Net Barter Terms of Trade

The commodity or net barter terms of trade is the ratio between the price of a country’s
export goods and import goods. Symbolically, it can be expressed as

Tc = Px / Pm

Where Tc stands for the commodity terms of trade, P for price, the subscript x for
exports and m for imports.

To measure changes in the commodity terms of trade over a period, the ratio of the
change in export prices to the change in import prices is taken. Then the formula for the
commodity terms of trade is
𝑃𝑃𝑃𝑃1 𝑃𝑃𝑃𝑃 1
Tc =
𝑃𝑃𝑃𝑃0 𝑃𝑃𝑃𝑃 0

Where the subscripts 0 and 1 indicate the base and end periods.

Taking 2001 as the base year and expressing Nigeria’s both export prices and import
prices as 100, if we find that by the end of 2011 its index of export prices had fallen to
90 and the index of import prices had risen to 110. The terms of trade had changed and
will be calculated as follows;
90 110
Tc = / = 81.82
100 100

It implies that Nigeria’s terms of trade declined by about 18 per cent in a decade (i.e.
2001 compared with 2011), thereby showing worsening of its terms of trade.

Gross Barter Terms of Trade.

The gross barter terms of trade is the ratio between the quantities of a country’s imports
and exports. Symbolically, Tg = Qm/Qx, where Tg stands for the gross terms of trade, Qm
for quantities of Imports and Qx for quantities of exports. The higher the ratio between
quantities of import and export, the better the gross term of trade. To measure changes in
the gross barter terms of trade over a period, the index number of the quantities of
imports and exports in base period (usually yearly) and the end period are related to each
other. The formula is as follows:
𝑄𝑄𝑄𝑄 1 𝑄𝑄𝑄𝑄1
Tg =
𝑄𝑄𝑄𝑄 0 𝑄𝑄𝑄𝑄0
Taking 2001 as the base year and expressing Nigeria’s both quantities of imports and
exports as 100, if we find that the index of quantity imports had risen to 160 and that of
quantity exports to 120 in 2011then the gross barter of trade had changed as follows.
160 120
Tg = = 133.33
100 100

It implies that there was an improvement in the gross barter terms of trade of Nigeria by
33 per cent in 2011 when compared with 2001.

If the quantity of import index had risen by 130 and that of quantity exports by 180, then
the gross barter terms of trade would be 72.22.
130 180
Tg = / = 72.22
100 100

This implies deterioration in the terms of trade by 18 per cent in 2011 over 2001. When
the net barter terms of trade (Tc) equals the gross barter terms of trade (Tg), the country
has balance of trade equilibrium. It shows that total receipts from exports of goods equal
total payments for import goods.

Numerically:

Px × Qx = Pm × Qm
𝑃𝑃𝑃𝑃 𝑄𝑄𝑄𝑄
Or =
𝑃𝑃𝑃𝑃 𝑄𝑄𝑄𝑄

Or 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

Or Tc = Tg
Self Assessment exercise:
Differentiate between the commodity barter terms of trade and gross barter terms of trade
3.2 Income Terms of Trade

Dorrance has improved upon the concept of the net barter terms of trade by formulating
the concept of the income terms of trade. This index takes into account the volume of
exports of a country and its export and import prices (the net barter terms of trade). It
shows a country’s changing import capacity in relation to changes in its exports. Thus,
the income terms of trade is the net barter terms of trade of a country multiplied by its
export volume index. It can be expressed as
𝑃𝑃𝑃𝑃
Ty = Tc.Qx = Px.Qx = Index of Export Prices × Export Quantity �𝑤𝑤ℎ𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 = � 𝑃𝑃𝑃𝑃 �
Pm Index of Import Prices
i.e. Ty is the income terms of trade; Tc the commodity terms of trade; and Qx the export
volume index. This index could be calculated by dividing the index of the value of
exports by an index of the price of imports, and it is called the “Export Gain from Trade
Index”.

Taking 2001 as the base year, if

Px = 140, Pm = 70 and Qx = 80 in 2011, then

140×80
PY = = 160
70

It implies that there is improvement in terms of trade by 60 per cent in 2011 as compared
with 2001.

If in 2011, Px = 80, Pm = 160 and Qx = 120,

Then,
80×120
Py = = 60
160

It implies that the income terms of trade have deteriorated by 40 per cent in 2011 as
compared with 2001.

A rise in then index of income terms of trade implies that a country can import more
goods in exchange for its exports. A country’s income terms of trade may improve but its
commodity terms of trade may deteriorate. Taking the import prices to be constant, if
export prices falls, there will be an increase in the salesand value of exports. Thus while
the income terms of trade might have improved, the commodity terms of trade might
have deteriorated.

The income terms of trade is called the capacity to import. In the long-run, the total value
of exports of a country must equal to its total value of imports, i.e. Px.Qx = Pm.Qm or
Px/Qx. Qx/Pm = Qm. Thus Px.Qx/Pm determines Qm which is the total volume that a
country can import. The capacity to import of a country may increase if other things
remain the same (i) the price of exports (Px) rises, or (ii) the price of imports (Pm) falls, or
(iii) the volume of its exports (Qx) rises. Thus the concept of the income terms of trade is
of much practical value for developing countries having low capacity to import.
Self Assessment exercise:
Explain in details the income terms of trade and how is different from the net barter terms
of trade.
3.3 Single Factoral Terms of Trade and Double Factoral Terms of Trade

Single Factoral Terms of Trade

The concept of commodity terms of trade does not take account of productivity changes
in export industries. However this has led to the development of the concept of single
factoral terms of trade which allows changes in the domestic export sector. It is
calculated by multiplying the commodity terms of trade index by an index of productivity
changes in domestic export industries. It can be expressed as:
𝑃𝑃𝑃𝑃 .𝐹𝐹𝐹𝐹 𝑃𝑃𝑃𝑃
Ts = Tc.Fx = �∴ 𝑇𝑇𝑇𝑇 = � �
𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃

Where Ts is the single factoral terms of trade, Tc is the commodity terms of trade, and Fx
is the productivity index of export industries.

It shows that a country’s factoral terms of trade improve as productivity improves its
export industries. If the productivity of a country’s exports industries increases, its
factoral terms of trade may improve even though its commodity terms of trade may
deteriorate. For example, the prices of its exports may fall relatively to its import prices
as a result of increase in the productivity of the export industries of a country. The
commodity terms of trade will deteriorate but it’s factoral; terms of trade will show an
improvement.

Double Factoral Terms of Trade

The double factoral terms of trade take into account productivity changes both in the
domestic export sector and the foreign export sector producing the country’s imports. The
index measuring the double factoral terms of trade can be expressed as
𝐹𝐹𝐹𝐹 𝑃𝑃𝑃𝑃 𝐹𝐹𝐹𝐹 𝑃𝑃𝑃𝑃
Td = Tc. = �𝑖𝑖. 𝑒𝑒. 𝑇𝑇𝑇𝑇 = � �
𝐹𝐹𝐹𝐹 𝐹𝐹𝐹𝐹 𝐹𝐹𝐹𝐹 𝑃𝑃𝑃𝑃

Where Td is the double factoral terms of trade, Px/Pm is the commodity terms of trade, Fx
is the export productivity index, and Fm is the import productivity index. It helps in
measuring the change in the rate of exchange of a country as a result of the change in
manufacturing imports of a country. A rise in the index of double factoral terms of a
country means that the productive efficiency of the factors has increased relatively to the
factors producing imports in the other country.
Self Assessment exercise:
How is the double factoral term of trade different from the single factoral terms of trade.
3.4 Real Cost Terms of Trade and Utility Terms of Trade.

Real Cost Terms of Trade

Viner has also developed a terms of trade index to measure the real gain from
international trade. He calls it the real cost terms of trade index. This index is calculated
by multiplying the single factoral terms of trade with the reciprocal of an index of the
amount of disutility per unit of productive resources used in producing export
commodities. It can be expressed as:
𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃
Tr = Ts.Rx = �∴ 𝑇𝑇𝑇𝑇 = � . 𝐹𝐹𝐹𝐹�
𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃

Where Tr is the real cost terms of trade, Ts is the single factoral terms of trade and Rx is
the index of the amount of disutility per unit of productive resources used in producing
export commodities.

Utility Terms of Trade

The utility terms of trade index measures “changes in the disutility of producing a unit of
exports and changes in the relative satisfactions yielded by imports and the domestic
products foregone as the result of export production.” In other words, it is an index of the
relative utility of imports and domestic commodities forgone to produce exports. The
utility terms of trade index is calculated by multiplying the real cost terms of trade index
with an index of the relative average utility of imports and of domestic commodities
foregone. If we denote the average utility by u and the domestic commodities whose
𝑈𝑈𝑈𝑈 1 𝑈𝑈𝑈𝑈 0
consumption is foregone to use resources for export production by a, then u = ,
𝑈𝑈𝑈𝑈 1 𝑈𝑈𝑈𝑈 0
where u is the index of relative utility of imports and domestically foregone commodities.
Thus, the utility terms of trade index can be expressed as:
𝑃𝑃𝑃𝑃
Tu = Tr.u = . Fx.Rx.u
𝑃𝑃𝑃𝑃

Since the real terms of trade index and utility terms of trade index involve the
measurement of disutility in terms of pain, irksomeness and sacrifice, they are elusive
concepts. As a matter of fact, it is not possible to measure disutility (for utility) in
concrete terms.
Self Assessment exercise:
Differentiate among the terms of trade known to you?
4.0 Conclusion

We conclude that the various types of terms of trade shows that the term, term of trade
could mean different thing in different situation. However, this unit has been written in a
way that learner will find it easy to understand and retained.

5.0 Summary
We defined different terms of trade that exist in the literature and their interrelationship.
This concept of terms of trade and its variants were clearly explained and distinguished,
in order to drive home the point for clearer understanding of the student.
6.0 Tutor-Marked Assignment
a) Explain what is meant by terms of trade.
b) Enumerate and explain all types of terms of trade known to you
c) Evaluate the most potent terms of trade among the various variants you know.
7.0 References/Further Readings
Amacher, R & Ulbrich, H, (1986); Principles of Economics, South Western
Publications Co. Cincinnafi, Oliso.

Arnold Kling (2012) ; the coincise encyclopaedia of economics, international trade

library of economy liberty.

Attah B.O, Bakare, T.A. & Daisi, O.R., (2011); Anatomy of Economics Principles,
Q&A (Macroeconomics), Raamson Printing Press, Oke-Afa, Isolo, Lagos, Nigeria

Familoni K.A, (1990); Development in Macroeconomics Policy, Concept

Publications, Lagos, Nigeria

Jhingan M.L, (2010); International Economics, 6th edition, Vrinda Publications (P)
Ltd. Delhi, India

Jhingan M.L, (2010); Macroeconomics Theory, 12th edition, Vrinda Publications (P)
Ltd. Delhi, India

Krugman Obstfeld, (1975); International Economics Theory and Policy, 8th edition
Pearson International edition,.
 UNIT 3: BALANCE OF TRADE AND BALANCE OF PAYMENT
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Balance of Trade
3.2 Concept of Balance of Payment
3.3 Comparison between Balance of Trade and Balance of Payment
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Readings

1.0 Introduction
This unit will discuss the concept of balance of trade and balance of payment, the
components of balance of payment and the relationship that exist between balance of
trade and payment,
2.0 Objective
Under this unit student should be able to
• Explain the concepts of balance of trade and its importance to a country
• Understand the meaning of balance of payment and the various components
that make up the balance of payment
• Differentiate between balance of trade and balance of payment.

3.0 Main Content

3.1Balance of Trade

The balance of trade (BOT) is the difference between a country's imports and its exports for
a given time period. The balance of trade is the largest component of the country's balance of
payments (BOP). Economists use the BOT as a statistical tool to understand the relative
strength of a country's economy versus other countries' economies and the flow of trade
between nations. The balance of trade is also known as the trade balance or the international
trade balance.
A country that imports more goods and services than it exports has a trade deficit.
Conversely, if a country exports more goods and services than it imports it will have a trade
surplus. A trade surplus or deficit, taken on its own, is not necessarily a viable indicator of an
economy's health. The numbers must be taken in context relative to the business cycle and
other economic indicators. For example, in a recession, countries like to export more,
creating jobs and demand in the economy. In a strong expansion, countries prefer to import
more, providing price competition, which limits inflation.The formula for calculating the
BOT can be simplified to imports minus exports. However, the actual calculation is
comprised of several elements.

• To make complete sense, the raw number of the trade deficit or surplus must be
compared to the country's gross domestic product (GDP), since larger economies
may be better suited to handle large deficits and surpluses.
• Detailed Formula for the Calculation of a Country's BOT
• Debit items include imports, foreign aid, domestic spending abroad and domestic
investments abroad. Credit items include exports, foreign spending in the domestic
economy and foreign investments in the domestic economy. By subtracting the
credit items from the debit items, economists arrive at a trade deficit or trade
surplus for a given country over the period of a month, quarter or year.
Self Assessment exercise:
Explain what you understand by balance of trade.
3.2Concept of Balance of Payment
The balance of payments which is also known as balance of international payments
(abbreviated as BOP), of a country is the record of all international economic transactions
between the residents of the country and the rest of the world, in a particular period of
time, commonly over a year.
BOP can also be described as financial statement that summarizes all
economy’s transactions with the rest of the world for a specific period of time. Moreso,
the balance of payments, encompasses all transactions between a country’s residents and
its non-residents involving goods, services and income; financial claims on
and liabilities to the rest of the world; and transfers such as gifts and aids. The balance
of payments classifies these transactions in two accounts which are its main component –
the current account and the capital account. The current account includes transactions in
goods, services, investment income and current transfers, while the capital
account mainly includes transactions in financial instruments. An economy’s balance of
payments transactions and international investment position (IIP) together constitute its
set of international accounts.
However, the balance of payments data is not concerned with actual payments made and
received by an economy, but rather with transactions. Since many international
transactions included in the balance of payments do not involve the payment of money,
this figure may differ significantly from net payments made to foreign entities over a
period of time. This led us to ask the following fundamental question, whether or notthe
 balance of payments actually balance always? In theory, a current account deficit would
have to be financed by a net inflow in the capital and financial account, while a current
account surplus should correspond to an outflow in the capital and financial account for a
net figure of zero. In actual practice, however, the fact that data are compiled from multiple
sources gives rise to some degree of measurement error.

The main components of the Balance of Payments are:

i. The Current Account including Merchandise (Exports Imports), Investment
income (rents, profits, interest.
ii. The Capital Account measuring foreign investment in the Nigerian economy and
Nigerian investments abroad.
These BOP components can be further decomposed as follows:
The commercial balance or net exports (sometimes symbolized as NX), is the difference
between the monetary value of a nation's exports and imports over a certain period. If
exports of a country are greater in value than it imports, it is called a tradesurplus, positive
balance, or a "favourable balance", and conversely, if exports of a country are less in value
than it imports, it is called a trade deficit, negative balance, "unfavourable balance", or,
informally, a "trade gap".

The financial account differs from the capital account in that, the capital account deals with
transfers of capital assets. A reflection of the country’s current trade balance combined with
net income and direct payments, (the current account serves to measure imports and exports
of goods and services), when combined with the financial and capital accounts, these
accounts form the country’s balance of payments

Self Assessment exercise:

What is balance of payment and what are the components that make up balance of payment.

3.3 Comparisonbetween Balance of Trade and Balance of Payment

The following are the major differences between the balance of trade and balance of
payments:

1. A statement recording the imports and exports carried out in goods by/from the
country with the other countries, during a particular period is known as the Balance of
Trade. The Balance of Payment captures all the monetary transaction performed
internationally by the country during a period of time.
2. The Balance of Trade accounts for, only physical items, whereas Balance of Payment
keeps track of physical as well as non-physical items.
3. The Balance of Payments records capital receipts or payments, but Balance of Trade
does not include it.
 4. The Balance of Trade can show a surplus, deficit or it can be balanced too.The same
goes for Balance of Payments.
5. The Balance of Trade is a major segment of Balance of Payment.
6. The Balance of Trade provides the only half picture of the country’s economic
position. Conversely, Balance of Payment gives a complete view of the
country’s economic position. The following chart can be use as a comparison of
balance of trade and balance of payment

Basis for
Balance of Trade Balance of Payment
Comparison

Balance of Trade is a statement Balance of Payment is a statement

that captures the country's export that keeps track of all economic
Meaning
and import of goods with the transactions done by the country with
remaining world. the remaining world.

Transactions related to both goods

Records Transactions related to goods only.
and services are recorded.

Capital Are not included in the Balance of

Are included in Balance of Payment.
Transfers Trade.

Which is It gives a partial view of the It gives a clear view of the economic
better? country's economic status. position of the country.

It can be favourable, unfavourable Both the receipts and payment sides

Result
or balanced. shouldtally.

It is a component of Current Current Account and Capital

Component
Account of Balance of Payment. Account.

Self Assessment exercise:

Give a comparison between balance of trade and balance of payment

4.0 Conclusion

We conclude that the various concepts of international trade are interrelated and as such
could be confusing if they are not properly assimilated and diffused. For instance balance
of trade and balance of payments. However, this unit has been written in a way that
learner will find it easy to understand and retained.
5.0 Summary
We defined various concepts that are related to international trade and finance and
juxtapose where necessary to distinguished among these concepts. The concept of
balance of trade and payment were clearly explained and distinguished..
6.0 Tutor-Marked Assignment
a) Evaluate the similarities and dissimilarities between balance of trade and balance of
payment.
b) Why must the balance of payment of any countries be balance?
c) Discuss the various components of balance of payment
7.0 References/Further Readings
Jhingan M.L, (2010); International Economics, 6th edition, Vrinda Publications (P)
Ltd. Delhi, India

Jhingan M.L, (2010); Macroeconomics Theory, 12th edition, Vrinda Publications (P)
Ltd. Delhi, India

Krugman Obstfeld, (1975); International Economics Theory and Policy, 8th edition
Pearson International edition.

Suranovic Steven M. (2010). International Trade Theory and Policy, Flat world
Knowledge. International Economics Study Center.
 MODULE THREE
INTERNATIONAL TRADE BENEFITS AND DUMPING

Unit 1: Benefit and Gains from Trade

Unit 2: Concepts of Dumping
Unit 3: Trade Controls

UNIT 1: BENEFIT AND GAINS FROM TRADE

CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Benefits of International Trade to Developing Countries
3.2 Analysis of Gains from Trade
3.3 Actual and Potential Gains from International Trade
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Readings

1.0 Introduction
This unit looked at the reasons why countries trade among one and other. It further
discusses the benefits of international trade to developing nations such as Nigeria, and
equally expounds the gains from trade for countries bringing into focus the actual and
potential gains from international trade.
2.0Objective
At the end of this unit student should be able to
• Know the benefit of International Trade to the developing nations
• Explain the gains from trade
• Understand the actual and potential gains from international trade.
3.0 Main Content
3.1Benefits of International Trade to Developing Countries
Free trade is an economic practice whereby countries can import and export goods
without fear of government intervention. Government intervention includes tariffs and
import/export bans or other limitations. Free trade offers several benefits to countries,
especially those in the developing stage. "Developing countries" is a broad term.
According to a widely used definition, a developing country is a nation with low levels of
economic resources (or utilization) and/or low standard of living. Developing countries
can often advance their economy through strategic free trade agreements. The following
are the benefits a developing nation could derive from participating in trade with other
countries of the world.
i. Increased Resources
Developing countries can benefit from free trade by increasing their amount of or access
to global economic resources. Nations usually have limited economic resources.
Economic resources include land, labour and capital. Land represents the natural
resources found within a nation and its borders. Small developing nations often have the
lowest amounts of natural resources in the economic marketplace. Free trade agreements
ensure that small nations obtain the economic resources needed to produce consumer
goods or services.
ii. Improved Quality of Life
Free trade usually improves the quality of life for a nation and its citizens. Nations can
import goods that are not readily available within their borders. Importing goods may be
cheaper for a developing country than attempting to produce consumer goods or services
within their borders. Many developing nations do not have the production processes
available for converting raw materials into valuable consumer goods. Developing
countries with friendly neighbours may also be able to import goods more often.
Importing from neighbouring countries ensures a constant flow of goods that are readily
available for consumption.
iii. Better Foreign Relations
Better foreign relation is usually an unintended result of free trade. Developing nations
are often subject to international threats. Developing strategic free trade relations with
more powerful countries can help ensure a developing nation has additional protection
from international threats. Developing countries can also use free trade agreements to
improve their military strength and their internal infrastructure, as well as to improve
politically. This unintended benefit allows developing countries to learn how they should
govern their economy and what types of government policies can best benefit their
people.
iv. Production Efficiency
Developing countries can use free trade to improve their production efficiency. Most
nations are capable of producing some type of goods or service. However, a lack of
knowledge or proper resources can make production inefficient or ineffective. Free trade
allows developing countries to fill in the gaps regarding their production processes.
Individual citizens may also visit foreign countries to increase education or experience in
specific production or business methods. These individuals can then bring back crucial
information about improving the nation and its production processes
Self Assessment exercise:
What are the benefits of international trade for Nigeria?

3.2 Analysis of Gains from Trade

The gains from trade refer to net benefits or increase in goods that a country obtains by
trading with other countries. It also means the increase in the consumption of a country
resulting from exchange of goods and specialization in production through international
trade. The gain from trade was at the core of the classical theory of international trade.
According to Adam Smith; the gains from trade resulted from the advantages of division
of labour and specialization both at the national and international level. They were due
to the existence of absolute differences in costs, that is, each country would specialize in
the production of that commodity which it could produce more cheaply than other
countries and import those commodities which it could produce more dearly. Thus
international specialization would increase world output and benefit all the trading
countries.
For Ricardo, extension of international trade powerfully contributed to increase the mass
of commodities, and therefore, the sum of enjoyments obtain from the imported goods
through trade instead of domestic production. J.S.Mill analyzed the gains from
international trade in terms of his theory of reciprocal demand which depends upon the
terms of trade. In modern analysis, the gains from international trade refer to the gains
from exchange and the gains from specialization based on the general equilibrium
analysis. The table 1.1.1 and table 1.1.2 shed more numerical evidence.
Self Assessment exercise:
Discuss the various schools of thoughts that you know on gains from trade

Potential and Actual Gains from International Trade

Economists usually distinguish between potential and actual gain from international
trade. The potential gains from international trade is the difference in domestic cost ratios
of producing two commodities in two countries. If X and Y are two commodities and A
and B two countries, then the potential gain can be expressed as
𝐶𝐶𝐶𝐶 𝐶𝐶𝐶𝐶
Gp = � �A - � �B
𝐶𝐶𝐶𝐶 𝐶𝐶𝐶𝐶

Where Gp is the potential gain, Cx is the cost per unit of commodity X, Cy is the cost per
unit of commodity Y, and the subscripts A and B refer to the two countries.
On the other hand, the actual gain from international trade is the difference in price ratios
of two commodities in the two trading countries. Assuming X and Y as two commodities
and A and B as two countries, the actual gain can be shown thus
𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃
GA = � �A - � �B
𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃
Where GA is the actual gain, Px is the per unit price of commodity X and Py is the per
unit price of commodity Y. under perfect competition and free trade between two
countries, the cost ratio equals the price ratio of the two commodities in each country so
𝐶𝐶𝐶𝐶 𝑃𝑃𝑃𝑃
that the potential gain equals the actual gain, � � = � � , therefore, GP = GA. But if there
𝐶𝐶𝐶𝐶 𝑃𝑃𝑃𝑃
are tariffs and other trade restrictions and commodity and factor markets are imperfect,
the price and cost ratios will not be equal in each country. If the price ratio is more than
𝑃𝑃𝑃𝑃 𝐶𝐶𝐶𝐶
the cost ratio, the actual gain will be less than the potential gain. Symbolically, � �>� �,
𝑃𝑃𝑃𝑃 𝐶𝐶𝐶𝐶
therefore, GA< GP
Since there is always imperfect competition in world markets then we can conclude that
the actual gain is always less than the potential gain in international trade.
Self Assessment exercise:
Differentiate between the potential and actual gains from international trade.

4.0 Conclusion
We conclude that the benefit from international trade cannot be overemphasized while
explaining the actual benefit that could accrued to developing nations. The actual and
potential gains from trade were discussed and we equally conclude that international
trade markets are imperfect and so potential gains are always more than actual gains

5.0 Summary

We enumerated various benefits from international trade to developing countries. The

gains from trade were enumerated and discussed. These gains from trade were discussed
under two forms, the potential gains and the actual gains and we summarised that
potential gains are always greater than the actual gains in an imperfect competitive
market which is the world kind of market.
6.0. Tutor-Marked Assignment
a) Examine the reason for engagement in international trade
b) Differentiate between actual and potential gains.
c) Explain what is meant by potential gains?
d) What is the relationship between actual and potential gains from trade in a
perfectly competitive international market?
7.0 References/Further Readings
Arnold Kling (2012). The Concise encyclopaedia of economics, international trade
library of economy liberty.
Attah B.O, Bakare, T.A. & Daisi, O.R., (2011); Anatomy of Economics Principles, Q&A
(Macroeconomics), Raamson Printing Press, Oke-Afa, Isolo, Lagos, Nigeria

Familoni K.A, (1990); Development in Macroeconomics Policy, Concept Publications,

Lagos, Nigeria

Jhingan M.L, (2010); International Economics, 6th edition, Vrinda Publications (P)
Ltd. Delhi, India

Jhingan M.L, (2010); Macroeconomics Theory, 12th edition, Vrinda Publications (P)
Ltd. Delhi, India

Krugman Obstfeld, (1975); International Economics Theory and Policy, 8th edition
Pearson International edition,.

Olasupo Akano (1995); International trade theory and evidence, Rebonik publication Ltd,
lagos.
UNIT 2: CONCEPTS OF DUMPING
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Meaning of Dumping
3.2 Types of Dumping
3.3 Basic Objectives of Dumping
3.4 Price Determination under Dumping
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Readings

1.0 Introduction
This unit considered dumping which occurs when a manufacturer lowers the price of a
good entering a foreign market than it charges domestic customers. The identification of
trade dumping can be performed simply by comparing the sales price of a good in its
market of origin and the price listed in an importing market. Trade dumping is considered
intentional in nature in that the primary purpose is to gain an advantage within the market
that imports the goods.

2.0Objective
At the end of this unit student should be able to
• Understand the meaning of dumping
• Explain the types of dumping
• Understand the basic objective of dumping
• Know the how price is determine under dumping
3.0 Main Content
3.1 Definition andMeaning of Dumping
Dumping is an international price discrimination in which an exporter firm sells a portion
of its output in a foreign market at a very low price and the remaining output at a high
price in the home market. Harberler defines dumping as: The sale of goods abroad at a
price which is lower than the selling price of the same goods at the same time and in the
same circumstances to home, taking account of differences in transport costs. In the same
vein dumping could be described as price discrimination between two markets in which
the monopolist sells a portion of his produced product at a low price and the remaining
part at a high price in the domestic market. There are two classification of dumping.
Firstly, reverse dumping in which the foreign price is higher than the domestic price. This
is done to turn out foreign competitors from the domestic market. When the product is
sold at a price lower than the cost of production in the domestic market, it is called
reverse dumping. Secondly, when there is no consumption of the commodity in the
domestic market and it is sold in two different foreign markets, out of which one market
is charged a high price and the other market a low price. However, in practice, dumping
mean selling of a product at a high price in the domestic market and a low price in the
foreign market.
Self Assessment exercise:
What is dumping?

3.2 Types of Dumping

Dumping can be typified in the following three ways:
1. Sporadic or Intermittent Dumping. It is adopted under exceptional or
unforeseen circumstances when the domestic production of the commodity is more
than the target or there are unsold stocks of the commodity even after sales. In
such a situation, the producer sells the unsold stocks at a low price in the foreign
market without reducing the domestic price. This is possible only if the foreign
demand for this commodity is elastic and the producer is a monopolist in the
domestic market. His aim may be to identify his commodity in a new market or to
establish himself in a foreign market to drive out a competitor from a foreign
market. In this type of dumping, the producer sells his commodity in a foreign
country at a price which covers his variable costs and some current fixed costs in
order to reduce his loss.
2. Persistent Dumping. When a monopolist continuously sells a portion of his
commodity at a high price in the domestic market and the remaining output at a
low price in the foreign market, it is called persistent dumping. This is possible
only if the domestic demand for that commodity is less elastic and the foreign
demand is highly elastic. When costs fall continuously along with increasing
production, the producer does not lower the price of the product more in the
domestic market because the home demand is less elastic. However, he keeps a
low price in the foreign market because the demand is highly elastic there. Thus,
he earns more profit by selling more quantity of the commodity in the foreign
market. As a result, the domestic consumers also benefit from it because the price
they are required to pay is less than in the absence of dumping.
3. Predatory Dumping. The predatory dumping is the one in which a monopolist
firms sells its commodity at a very low price or at a loss in the foreign market in
 order to drive out some competitors. But when the competition ends, it raises the
price of the commodity in the foreign market. Thus, the firm covers loss and if the
demand in the foreign market is less elastic, its profit may be more.
Self Assessment exercise:
Discuss the various types of dumping that you know?

3.3 Objectives of Dumping

The following are the objectives of dumping:
To Find a Place in the Foreign Market. A monopolist resorts to dumping in order to
find a place or to continue himself in the foreign market. Due to perfect competition in
the foreign market, he lowers the price of his commodity in comparison to the other
competitors so that the demand for his commodity may increase. For this, he often sells
his commodity by incurring loss in the foreign market.
To Sell Surplus Commodity. When there is excessive production of a monopolist’s
commodity and he is not able to sell in the domestic market, he wants to sell the surplus
at a very low price in the foreign market. But it happens occasionally.
Expansion of Industry. A monopolist also resorts to dumping for the expansion of his
industry. When he expands it, he receives both internal and external economics which
lead to the application of the law of increasing returns. Consequently, the cost of
production of his commodity is reduced and by selling more quantity of his commodity at
a lower price in the foreign market, he earns lager profit.
New Trade Relations. The monopolist practices dumping in order to develop new trade
relations abroad. For this, he sells his commodity at a low price in the new market,
thereby establishing new market relations with those countries. As a result, the
monopolist increases his production, lowers his costs and earns more profit.
Self Assessment exercise:
Discuss the various types of dumping that you know?

3.4 Price Determination under Dumping

In practice price determination underdumping is just like discriminating monopoly. The
only difference between the two is that under discriminating monopoly both markets are
domestic while in dumping one is a domestic market and the other is a foreign market. In
dumping, a monopolist sells his commodity at a high price in the domestic market and at
a low price in the foreign market.
The main aim of the monopolist is to maximize his profit. He, therefore, produces that
output at which his marginal revenue equals marginal cost. Since he sells his commodity
in the domestic market and the foreign market separately, he adjusts the quantity such as
wise in each market that marginal revenues in both markets are equals. Given the
marginal cost of producing the commodity, of a specific volume or value is allowed to be
import into the country. For this purpose, it includes the imposition of a duty along with
fixing quota, and providing a limited amount of foreign exchange to the importers.
Self Assessment exercise:
Is dumping an economic vice or virtue?
4.0 Conclusion
We conclude that dumping is a problem to the end country because it kills infant industry
and reduce the country’s level of international competitiveness. But if the products
involve are not locally produce efficiently or the resources to produce could not be
efficiently sourced locally, then dumping could be seen as virtue than vice.
5.0 Summary
This study unit looked into the concept of dumping and explain its various kind, reasons
for dumping and how it could be controlled. This study further reiterates that dumping is
not bad in entirety.
6.0 Tutor-Marked Assignment
a) Enumerate and explain various type of dumping
b) Give four objectives of dumping
c) What are the major control of dumping
d) Explain what is meant by dumping
e) Evaluate possible effect of dumping on receiving country
f) What are the immediate benefit of dumping to the country of origin?
7.0 References/Further Readings
Amacher, R & Ulbrich, H, (1986); Principles of Economics, South Western Publications
Co. Cincinnafi, Oliso.

Arnold Kling (2012) ; the coincise encyclopaedia of economics, international trade

library of economy liberty.

Attah B.O, Bakare, T.A. & Daisi, O.R., (2011); Anatomy of Economics Principles, Q&A
(Macroeconomics), Raamson Printing Press, Oke-Afa, Isolo, Lagos, Nigeria

Familoni K.A, (1990); Development in Macroeconomics Policy, Concept Publications,

Lagos, Nigeria

Frederic S. Mishkin, (2012); The Economics of Money, Banking and Financial Markets,
10th edition, Pearson.
Jhingan M.L, (2010); International Economics, 6th edition, Vrinda Publications (P)
Ltd. Delhi, India

Jhingan M.L, (2010); Macroeconomics Theory, 12th edition, Vrinda Publications (P)
Ltd. Delhi, India

Krugman Obstfeld, (1975); International Economics Theory and Policy, 8th edition
Pearson International edition,.

Olasupo Akano (1995); International trade theory and evidence, Rebonik publication Ltd,
lagos,
UNIT 3: TRADE CONTROLS
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Tariffs
3.2 Non Tariff Controls
3.3 Comparison of Tariffs and Non Tariffs
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Readings

1.0 Introduction
When country import goods from foreign countries at cheap prices it will affect domestic
producers badly. As such, countries impose taxes on goods coming from abroad to make
their cost comparable with domestic goods. These are called tariff barriers. Then there are
non tariff barriers also that serve as impediments in free international trade. This unit will
try to discuss these concepts of trade control and also find out the differences between
tariff and non tariff barriers.
2.0Objective
At the end of this unit student should be able to

• Understand the concept of tariff and why tariff is impose in a country

• Distinguish between the various types of non tariff barriers
• Understand the differences between tariff and non tariff controls
3.0 Main Content
3.1 Tariff

This is a tax imposed on imported goods and services. Tariffs are used to restrict trade, as
they increase the price of imported goods and services, making them more expensive to
consumers. A specific tariff is levied as a fixed fee based on the type of item (e.g.,
N100,000 on any car). An ad-valorem tariff is levied based on the item’s value (e.g., 10%
of the car’s value). Tariffs provide additional revenue for governments and domestic
producers at the expense of consumers and foreign producers. They are one of several
tools available to shape trade policy.
Governments may impose tariffs to raise revenue or to protect domestic industries from
foreign competition, since consumers will generally purchase foreign-produced goods
when they are cheaper. While consumers are not legally prohibited from purchasing
foreign-produced goods, tariffs make those goods more expensive, which give consumers
an incentive to buy domestically produced goods that has competitively priced or less
expensive by comparison. Tariffs can make domestic industries less efficient, since they
are not subject to global competition. Tariffs can also lead to trade wars as exporting
countries reciprocate with their own tariffs on imported goods. Groups such as the World
Trade Organizationexist to combat the use of destructive tariffs.

Government normally use one of the following justifications for implementing tariffs:

• To protect domestic jobs. If consumers buy less expensive foreign goods, workers
who produce that good domestically might lose their jobs.
• To protect infant industries. If a country wants to develop its own industry
producing a particular good, it will use tariffs to make it more expensive for
consumers to purchase the foreign version of that good. The hope is that they will
buy the domestic one instead and help that industry grow.
• To retaliate against a trading partner. If one country does not play by the trade
rules both countries previously agreed on, the country that feels jilted might
impose tariffs on its partner’s goods as a punishment. The higher price caused by
the tariff should cause purchases to fall.
• To protect consumers. If a government thinks a foreign good might be harmful, it
might implement a tariff to discourage consumers from buying it.

Self Assessment exercise:

Give reasons why government of a nation may impose tariff?
3.2 Non Tariff Controls

A nontariff barrier is a form of restrictive trade where barriers to trade are set up other
than a tariff. Nontariff barriers include quotas, embargoes, sanctions, levies and other
restrictions which are frequently used by large and developed economies. Nontariff
barriers are another way for an economy to control the amount of trade that it conducts
with another economy, either for selfish or unselfish purposes.

Nontariff barriers are commonly used by countries in international trade, and they are
typically based on the availability of goods and services and the political alliances with
the trading countries. Overall, any barrier to international trade will create an economic
loss, as it limits the functions of standard market trading. The lost revenues resulting from
the barrier to trade can be called an economic loss.
Countries can set various types of alternative barriers to standard tariffs, which often
release countries from paying added tax on imported goods and create other barriers
which have a meaningful yet different monetary impact.

Licenses
Countries may use licenses to limit imported goods to specific businesses. If a business is
granted a trade license, then it permits it to import goods that otherwise are restricted for
trade in the country.

Quotas
Countries typically use quotas for the importing and exporting of goods and services. In
nontariff barrier procedures, countries agree on specified limits of goods and services that
are permitted for importation to a country, naturally without restrictions, up to a specified
limit. Quotas can also be set for specific time frames. Additionally, quotas are also often
used in international trade license agreements.

Embargoes
Embargoes restrict the trade of specified goods and services. Embargoes are a measure
used by governments for specific political or health circumstances.

Sanctions
Countries impose sanctions on other countries to limit their trade activity. Sanctions can
include increased administrative actions and additional customs and trade procedures that
slow or limit a country’s ability to trade.

Voluntary Export Restraints

Voluntary export restraints are a type of nontariff barrier used by exporting countries.
Voluntary export restraints set specified limits of goods and services to be exported to
specified countries. These restraints are normally based on availability and political
alliance.

Standard Tariffs
Nontariff barriers can be used in place of or in conjunction with standard tariff barriers,
which are taxes that importing countries pay to exporting countries for goods or services.
Tariffs are the most common type of trade barrier, and they increase the cost of goods
and services for an importing country to the benefit of the exporting country.

Self Assessment exercise:

What do you understand by non tariff and discuss the various non tariff that exist in a
country?
3.3 Comparison of Tariffs and Non Tariffs

The following can be seen as the difference between tariff and non-tariff barriers:

1. When tariff is imposed the Government receives the revenue whereas no revenue is
received by the Government by applying non-tariff measures.However, it is favoured as
an appropriate measure to meet the demand of the country and to protect the industry.

2. Non-tariff measures protect the procedures and make them feel more secure than under
a tariff but incentives are not there under tariffs.

3. In tariff customer’s classification and valuation procedures pose a problem before the
customs authorities. Whereas under non-tariff measure no such problem arise.

4. Non-tariff barriers to trade induce the domestic producers to form monopolistic

organisations with a view to keep output low and prices high. This is not possible under
import duty.Non-tariff barriers remain ineffective if monopolistic tendencies prevail in
the country.

5. Non-tariff measures are flexible than tariff. Imposition of tariff and amendments are
subject to legislative enactment.

6. In non-tariff the price differences will be greater in two countries because there is no
free flow of imports; but in tariff price differentiation will be equal to the cost of tariff
and transportation between exporting and importing countries.

7. Tariffs are simple to operate. Tariff rates once fixed through legislation require no
individual allocation of licensing quotas or exchange.For non-tariff measures numbers of
authorities are there to administer. It may result in political interference or corruption.

8. Tariff favours particularly efficient firms in the country but non-tariff measures benefit
established firm because they get quotas or import licenses.

9. Non-tariffs discriminate against new-comers but tariff do not discriminate.

Self Assessment exercise:

Distinguish between tariff and non tariff?
4.0 Conclusion
This unit concludes that tariff and non tariff are both complementary trade instruments to
check against the backdrop of any abuse in the international trade. Both tariff and non
tariffs are domestic government trade instruments administer against trade abuses. It
should be noted that the two instruments could jointly be used or used independently.
5.0 Summary
This study unit looked into the concept of tariff and non tariff instruments and explain the
reasons for adopting different tariff at different situation. The unit also compare the
impart of tariff and non-tariff instrument on thein order to establish their relative
effectiveness as well as building up best form of control.
7.0 Tutor-Marked Assignment
a) Explain what is meant by non tariff trade instruments/ with example
b) Give four objectives of tariff
c) What are the major component of tariffs
d) Explain what is meant by tariff
e) What are the various types of tariff
f) Compare and contrast the concept of tariff and non tariff
7.0 References/Further Readings
Amacher, R & Ulbrich, H, (1986); Principles of Economics, South Western Publications
Co. Cincinnafi, Oliso.

Arnold Kling (2012) ; the coincise encyclopaedia of economics, international trade

library of economy liberty.

Frederic S. Mishkin, (2012); The Economics of Money, Banking and Financial Markets,
10th edition, Pearson.

Jhingan M.L, (2010); International Economics, 6th edition, Vrinda Publications (P)
Ltd. Delhi, India

Jhingan M.L, (2010); Macroeconomics Theory, 12th edition, Vrinda Publications (P)
Ltd. Delhi, India

Krugman Obstfeld, (1975); International Economics Theory and Policy, 8th edition
Pearson International edition,.

Roorbach G. (1993). Tariffs and Trade Barriers in relation to International Trade,

Proceedings of the Academy of Political Science, 15(2).

Yu Zhihao (2000). A Model of Substitution of Non Tariffs. The Canadian Journal of

Economics, 33 (4).
 MODULE FOUR
EARLY THEORIES OF INTERNATIONAL TRADE

Unit 1: Mercantilism
Unit 2: Absolute Cost Advantage Trade theory
Unit 3: Comparative Cost Advantage Trade Theory

UNIT 1: MERCANTILISM
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Meaning of Mercantilism
3.2 Basic Features and Argument for Mercantilism
3.3 Criticisms of Mercantilism
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Readings

1.0 Introduction

This unit will look at the theory of mercantilism which was the primary economic system
of trade used from the 16th to 18th century. Mercantilist theorists believed that the
amount of wealth in the world was static. Thus, European nations took several strides to
ensure their nations accumulated as much of this wealth as possible. The goal was to
increase a nation's wealth by imposing government regulation that oversaw all of the
nation's commercial interests. It was believed national strength could be maximized by
limiting imports via tariffs and maximizing exports.

2.0Objective
At the end of this unit student should be able to
• Understand the meaning of mercantilism
• Explain the argument that operate during the mercantilism period
• Understand the principle under lying the mercantilism theory
• Explain the criticism levied against the mercantilism
3.0 Main Content
3.1Meaning of Mercantilism

Mercantilism is the first theory of international trade; it is an economic concept for the
purpose of building a wealthy and powerful state, which believes that the wealth of a
nation could only be achieved through government controls and regulation of trade,
commerce and economic activities. It involves wealth accumulation, establishment of
favourable trade with other countries, and development of internal resources in the
manufacturing and agriculture sectors. The economic policies that are pursued by the
Mercantilists, such as Governmental control of the use and exchange of precious metals,
which is often referred to as Bullionism. Adam Smith coined the term “mercantile
system” to describe the system of political economy that sought to enrich the country by
restraining imports and encouraging exports. This system dominated Western European
economic thought and policies, including Portugal, France, Spain, and Great Britain from
the sixteenth to the late eighteenth centuries.

The basic concepts of mercantilism in terms of trading are: this approach assumes the
wealth of a nation depends primarily on the possession of precious metals such as gold
and silver. During 16th to 18th century, gold and silver were the currency of trade
between countries. By exporting goods, countries could earn and therefore maximize the
amount of gold and silver. Conversely, importing goods from other countries resulted in
an outflow of gold and silver to those countries. Also, mercantilism in terms of trading is
to make sure that the country’s own resources are exported to other countries in higher
volumes or amounts compared to the goods imported, which are kept to a minimum level.
Trading is said to be balanced if a country exports more than it imports. Through this
system, resources will increase and there will be a surplus of gold and silver reserves.
This theory suggests that the government should play an active role in the economy by
encouraging exports and discouraging imports, especially through the use of tariffs.

Self Assessment exercise:

How is the mercantilism different from other theories of international trade?
3.2 Basic Features and Argument for Mercantilism

There are some features of mercantilism and they are as follows:

1) Import prohibition of certain goods using imposition of high tariffs, government

legislation or very high taxes/import duties.

2) A wide range of government subsidies on export industries to promote the country’s

export-based policy.

3) Policies of nationalism.
4) Accumulation of assets in gold and silver, and prohibition of private accumulation, use
or export of these items.

5) One-way trade with colonies, and importation of gold and raw materials from these
sources.

Also the main policies of Mercantilist included: High tariffs, especially on manufactured
goods; Exclusive trade with colonies; Forbidding trade to be carried in foreign ships;
Export subsidies; Banning all export of gold and silver; Promoting manufacturing with
research or direct subsidies; Limiting wages; Maximizing the use of domestic resources.

Base on the above policies the following assumptions was made:

1) That there is finite amount of wealth in the world.

2) A nation can only grow rich at the expense of other nations.

3) Therefore, a nation should try to achieve and maintain a favourable trade balance,
exporting more than it imports. They use colonies to achieve a favourable trade balance
because 1) the economy of the colonies is always secondary to the economy of the
mother country.

2) Also the colonies provide cheap raw materials to the mother country and market the
manufactured goods of the mother country.

3) In return, the mother country provides military security and political administration to
the colonies.

4) The overriding goal is national monopoly, meaning that a nation’s colonies should be
restricted to trading only with each other or with the mother country.

Self Assessment exercise:

What are the assumptions of mercantilism that makes the policy operate effectively?
3.3 Criticism of Mercantilism

Neo-Mercantilists equate political power with economic power with a balance of trade
surplus. Critics argue that many nations have adopted a neo-mercantilist approach to
boost exports and minimize or limit imports. For example, China has recently been
criticized for using the mercantilist system, deliberately keeping its currency value low
against the U.S. dollar in order to sell more goods to the U.S. China for many years has
been successful at distributing their goods and services to other countries, and severely
limiting the imports they take in return. This has allowed China to amass considerable
wealth in foreign currencies. Economists point out, that like European countries who
eventually had to abandon mercantilism, China may be at that point as well, if they want
to continue to develop their wealth.

Adam Smith and David Hume were the founding fathers of anti-mercantilist thought; this
practice was strongly attacked by Adam Smith in his 1776 work “The Wealth of
Nations”. The criticisms of mercantilism are given elaborately that

Mercantilists viewed the economic system as a “zero-sum game”, in which a gain by one
country results in a loss by other. Adam Smith & David Ricardo argued that, trade should
be a positive-sum game, or a situation in which all countries can benefit.

Mercantilism unduly emphasized the importance of money and over-emphasized the

importance of gold and silver. So Mercantilist ideas about wealth were nonsensical and
untenable.

The mercantilists unduly emphasized the importance of a favourable balance of trade. For
the attainment of this objective they discouraged imports by imposing heavy and
prohibitive duties on foreign goods and provided every possible ways to minimize
exports. The mercantilist assumption that the colonies existed for the benefit of the
mother was not a sound economic proposition. Mercantilism was a cause of frequent
European wars in that time and motivated colonial expansion. The mercantilist policies
were designed to benefit the government and the commercial class, rather than the entire
population.

The mercantilism over-emphasized the importance of commerce and greatly undermined

the importance of agriculture and other branches of human industry. It does not promote
free enterprise and free movement of goods and people. And instead it allowed
colonialism and monopoly of businesses and trade practices. Objectives were simply to
generate wealth for the upper class and merchant class. The working people were
exploited and were even made as slaves with very low wages.

Finally, Smith argued that the collusive relationship between government and industry
was harmful to the general population. He criticized mercantilist trade policy of
intervening and monopolizing trade business.

Self Assessment exercise:

What are the bases of mercantilism criticism?
4.0 Conclusion

Mercantilist regulations were steadily removed over the course of the Eighteenth Century
in Britain, and during the 19th century the British government fully embraced free trade
and Smith's laissez-faire economics. In France, economic control remained in the hands
of the royal family and mercantilism continued until the French Revolution. The
continued pressure resulted in the implementation of laissez faire economics in the
nineteenth century.

5.0 Summary

From this unit we find out that mercantilism is an economic theory and practise where the
government seeks to regulate the economy and trade in order to promote domestic
industry often at the expense of other countries. Mercantilism is associated with policies
which restrict imports and foster domestic industries.Mercantilism stands in contrast to
the theory of free trade which argues countries economic well-being can be best
improved through reduction of tariffs and fair free trade.

6.0 Tutor-Marked Assignment

a. Mercantilism is a philosophy of a zero sum game where people benefit at the expense
of others. Discuss
b. What are the basic features of the mercantilism system?
c. Explain the argument put forward for the operation of mercantilism
d. Narrate the criticism of Adams Smith on mercantilism.
7.0 References/Further Readings
Jhingan M.L, (2010); International Economics, 6th edition, Vrinda Publications (P)
Ltd. Delhi, India

Jhingan M.L, (2010); Macroeconomics Theory, 12th edition, Vrinda Publications (P)
Ltd. Delhi, India

Krugman Obstfeld, (1975); International Economics Theory and Policy, 8th edition
Pearson International edition,.

Olasupo Akano (1995); International trade theory and evidence, Rebonik publication Ltd,
Lagos,

Laura Lattaye (2001). “Mercantilism” in the Concise Encyclopedia of Economic Online.

Mucusker John J. (2001). Mercantilism and the Economic History of the early Modern
Atlantic World, Cambridge UP.
UNIT 2: ABSOLUTE COST ADVANTAGE TRADE THEORY
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Meaning and Implications of the Theory
3.2 Assumptions and Illustration of the Theory
3.3 Criticisms of Absolute Cost Advantage Theory
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Readings

1.0 Introduction

Absolute advantage is the ability of a country, individual, company or region to produce a

good or service at a lower cost per unit than the cost at which any other entity produces
that same good or service. Entities with absolute advantages can produce a product or
service using a smaller number of inputs and/or using a more efficient process than other
entities producing the same product or service.

2.0Objective

At the end of this unit student should be able to

• Understand the meaning of absolute cost advantage trade theory
• Know the assumptions of absolute cost advantage theory
• Explain the illustration of the theory
• Know the criticisms of the theory
3.0 Main Content
3.1Meaning and Implications of the Theory
The main concept of absolute advantage is generally attributed to Adam Smith for his
1776 publication “An Inquiry into the Nature and Causes of the Wealth of Nations” in
which he countered mercantilist ideas.Adam Smith extolled the virtues of free trade.
These are the result of the advantages of division of labour at the international level
requires the existence of absolute differences in costs. Every country should specialize in
the production of that commodity which it can produce more cheaply than others and
exchange it for the commodities which cost less in other countries.
Smith argued that it was impossible for all nations to become rich simultaneously by
following mercantilism because the export of one nation is another nation’s import and
instead stated that all nations would gain simultaneously if they practiced free trade and
specialized in accordance with their absolute advantage. Smith also stated that the wealth
of nations depends upon the goods and services available to their citizens, rather than
their gold reserves.While there are possible gains from trade with absolute advantage, the
gains may not be mutually beneficial. Comparative advantage focuses on the range of
possible mutually beneficial exchanges.The implications of the Smiths’ trade theory are
that there will be;
i. More quantity of both products
ii.Increase standard of living of both countries
iii. Increaseproduction efficiency
iv. Increase in global efficiency and effectiveness
v. Maximization of global productivity and other resources productivity.

Self Assessment exercise:

Explain in detail Adam Smith’s theory of absolute cost advantage.
3.2 Assumptions and Illustration of the Theory
Adam Smith postulates the following assumptions for his trade theory:
i. That trade is between two countries
ii. Only two commodities are traded
iii. Free trade exists between the countries
iv. The only element of cost of production is labour.
To illustrate, let there be two countries, Nigeria and Ghana, having absolute differences
in costs in producing a commodity each, Peanuts and Millet respectively, at an absolute
lower cost of production than the other. The absolute cost differences are illustrated in
Table 4.2.1
Table 4.2.1 Absolute Differences in Costs
Country Peanuts Millets
Nigeria 10 5
Ghana 5 10

The table reveals that Nigeria can produce 10 units of peanuts or 5 units of millets with
one units of labour and Ghana can produce 5 units of peanuts or 10 units of millets with
one units of labour.
In this case, Nigeria has an absolute advantage in the production of peanuts (for 10 units
of peanuts is greater than 5 units of millets), and Ghana has an absolute advantage in the
production of millets (for 10units of millets is greater than 5units of peanuts).
Trade between the two countries will benefit both if Nigeria specializes in the
production of peanuts and Ghana in the production of millets, as shown in Table 4.2.2.

Table 4.2.2 Gains from Trade

Production before Production after Gains from Trade (2-

Trade (1) Trade (2) 1)
Country

PeanutsMillets Peanuts Millets Peanuts Millets

Nigeria 10 5 20 - +10 -5

Ghana 5 10 -20 -5 +10

Total 15 15 20 20 +5 +5
Production

The above table reveals that before trade both countries produce only 15 units each of
the two commodities by applying one labour-unit on each commodity. If Nigeria were to
specialize in producing peanuts and use both units of labour on it, its total production
will be 20 units of peanuts. Similarly, if Ghana were to specialize in the production of
millets alone, its total production will be 20 units of millets. The combined gain to both
countries from trade will be 5 units each of peanuts and millets.
Self Assessment exercise:
What are the assumptions ofAdam Smith’s theory of absolute cost advantage and give a
detail illustration of the theory.
3.3 Criticisms of Absolute Cost Advantage Theory

This theory has been criticized for it vagueness and lack of clarity. According to
Ellsworth, Smith assumes without argument that international trade requires a producer
of exports to have an absolute advantage, that is, an exporting country must be able to
produce with a given amount of capital and labour a larger output than rival. But this
basis of trade is not realistic because there are many underdeveloped countries which do
not possess absolute advantage in the production of any commodity, and yet they have
trade relations with other countries. Thus, Smith’s analysis is weak and unrealistic.
Other issue raise as criticism of the absolute cost advantage trade theory are;
i. There is no absolute advantage for many countries
ii. Country size varies
iii. There are differences in all countries specialisation
 iv. The theory deals with labour only and neglects other factors of production
v. It neglected transport cost which plays significant role in all trade
vi. It also neglected large scale production which brings about reduction in cost of
production.
Self Assessment exercise:
Analyse the criticisms of absolute cost advantage trade theory.
4.0 Conclusion

The classical economist of Smith's and others relied basically on laissez-faire principles
of economics. The theory of Absolute Advantage was clearly illustrated with it basic
assumptions and tables. The unit however shows the essentiality of trade between or
among nations.

5.0 Summary
Absolute advantage is predominantly a theory of international trade in which a country
can produce a good more efficiently than other countries. Countries that have an absolute
advantage can decide to specialize in producing and selling that specific product or
service, using the funds generated to purchase other goods and services that it does not
specialize in producing. The idea of absolute advantage was pioneered by Adam Smith in
the late 18th century as part of his division of labour doctrine.

6.0 Tutor-Marked Assignment

a. Global resources are more efficiently utilized under the absolute advantage doctrine.
Discuss
b. List and explain major characteristics of Adam Smith’s Absolute cost advantage
theory.
c. Describe how absolute advantage theory could lead to benefit in international trade
dealings.
d. Narrate the criticism of Adams Smith’s absolute advantage theory..
7.0 References/Further Readings
Amacher, R & Ulbrich, H, (1986); Principles of Economics, South Western Publications
Co. Cincinnafi, Oliso.

Arnold Kling (2012) ; the Concise encyclopaedia of economics, international trade

library of economy liberty.

Attah B.O, Bakare, T.A. & Daisi, O.R., (2011); Anatomy of Economics Principles, Q&A
(Macroeconomics), Raamson Printing Press, Oke-Afa, Isolo, Lagos, Nigeria
Frederic S. Mishkin, (2012); The Economics of Money, Banking and Financial Markets,
10th edition, Pearson.

Jhingan M.L, (2010); International Economics, 6th edition, Vrinda Publications (P)
Ltd. Delhi, India

Jhingan M.L, (2010); Macroeconomics Theory, 12th edition, Vrinda Publications (P)
Ltd. Delhi, India

Krugman Obstfeld, (1975); International Economics Theory and Policy, 8th edition
Pearson International edition,.

Olasupo Akano (1995); International trade theory and evidence, Rebonik publication Ltd,
Lagos.

Feentra Robert C. (2004). Advanced International Trade Theory and Evidence, Princeton,
New Jersey, Princeton University Press.
UNIT 3: COMPARATIVE ADVANTAGE TRADE THEORY
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Meaning and Assumption of Comparative Advantage Theory
3.2 Explanation of the theory and Gains from Trade
3.3 Criticisms of Ricardo’s Comparative Advantage Theory
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Readings

1.0 Introduction

The theory of comparative advantage is an economic theory about the work gains from
trade for individuals, firms, or nations that arise from differences in their factor
endowments or technological progress.In an economic model, agents have a comparative
advantage over others in producing a particular good if they can produce that good at a
lower relative opportunity cost or autarky price, i.e. at a lower relative marginal cost prior
to trade. One does not compare the monetary costs of production or even the resource
costs (labour needed per unit of output) of production. Instead, one must compare the
opportunity costs of producing goods across countries.The closely related law or
principle of comparative advantage holds that under free trade, an agent will produce
more of and consume less of a good for which they have a comparative advantage.

2.0Objective

At the end of this unit student should be able to

• Understand the meaning and assumption underlining the comparative
advantage trade theory.
• Understand the explanation and the benefits from trade under this theory
• Explain the criticisms of the comparative advantage theory
3.0 Main Content
3.1Meaning and Assumption of Comparative Advantage Theory

David Ricardodeveloped the classical theory of comparative advantage in 1817 to explain

why countries engage in international trade even when one country's workers are more
efficient at producing everysingle good than workers in other countries. He demonstrated
that if two countries capable of producing two commodities engage in the free market,
then each country will increase its overall consumption by exporting the good for which
it has a comparative advantage while importing the other good, provided that there exist
differences in labour productivitybetween both countries. Widely regarded as one of the
most powerful yet counter-intuitive insights in economics, Ricardo's theory implies that
comparative advantage rather than absolute advantage is responsible for much of
international trade.

According to David Ricardo, it is not the absolute but the comparative differences in
costs that determine trade relations between two countries. Production costs differ in
countries because of geographical division of labour and specialization in production.
Due to differences in climate, natural resources, geographical situation and efficiency of
labour, a country can produce one commodity at a lower cost than the other. In this way,
each country specializes in the production of that commodity in which its comparative
cost of production is the least. Therefore, when a country enters into trade with some
other country, it will export those commodities in which its comparative production cost
is less, and will import those commodities in which its comparative production cost are
high. This is the basis of international trade, according to Ricardo. It follows that each
country will specialize in the production of those commodities in which it has the greatest
advantage of the least comparative disadvantage. Thus, a country will export those
commodities in which its comparative advantage is the least.

Assumption of the Theory

The Ricardian theory of comparative advantage is based on the following assumptions:

1. There are only two countries, say Nigeria and Ghana

2. They produce the same two commodities; say cocoa and groundnut.
3. There are similar tastes in both countries.
4. Labour is the only factor of production.
5. The supply of labour is unchanged.
6. All units of labour are homogenouswithin a country but heterogeneous (non-
identical) across countries.
7. Prices of two commodities are determined by labour cost, i.e., the number of
labour-units employed to produce each.
8. Commodities are produced under the law of constant costs of returns
9. Technological knowledge is unchanged.
10. Trade between the two countries takes place on the basis of the barter system.
11. Factors of production are perfectly mobile within each country, but are perfectly
immobile between countries.
12. T here is free trade between the two countries, there being no trade barriers or
restrictions in the movement of commodities.
13. No transport costs are involved in carrying trade between the two countries.
14. All factors of production are fully employed in both the countries.
 15. The international market is perfect so that the exchange ratio for the two
commodities is the same.
Self Assessment exercise:
Explain in detail the Ricardo comparative cost advantage trade theory.
3.2 Explanation of the theory and Gains from Trade

With the above assumptions, Ricardo shows that trade is possible between two countries
when one country has an absolute advantage in the production of one commodity than in
the other. This is illustrated with trade between Nigeria and Ghana as shown in Table
4.3.1 below.

Table 4.3.1 Man-years of labour required for producing one unit

Country Cocoa Groundnut

Nigeria 12 10

Ghana 8 9

The table shows that the production of a unit of cocoa in Nigeria requires 12 men for a
year, while a unit of groundnut requires 10 men for the same period. On the other hand,
the production of the same quantities of cocoa and groundnut in Ghana requires 8 and 9
men respectively. Thus, Nigeria uses more labour than Ghana in producing both cocoa
and groundnut. In other words, the Ghana labour is more efficient than the Nigeria labour
in producing both of the products. So Ghana possesses an absolute advantage in both
cocoa and groundnut. But Ghana would benefit more by producing cocoa and exporting it
to Nigeria because it possesses greater comparative advantage in it. This is because the
cost of production of cocoa (8/12 men) is less than the cost of production of groundnut
(9/10 men). On the other hand, it is in Nigeria’s interest to specialize in the production of
groundnut in which it has the least comparative disadvantage. This is because the cost of
production in Nigeria in less (10/9 men) as compared with cocoa (12/8 men). Thus, trade
will be beneficial for both countries.

Gains from Trade:even though Ricardo does not discuss the actual ratio at which cocoa
and groundnut would be exchange and how much the two countries gain from trade.
Before trade, the domestic trade ratios in the two countries for wine and cloth are as
follows: the cost of production of one unit of cocoa in Nigeria is 12 men and that of
producing one unit of groundnut is 10 men. It shows that the cost of producing cocoa is
more as against groundnut because one unit of cocoa can exchange for 1.2 units of
groundnut. On the other hand, the cost of producing one unit of cocoa in Ghana is 8 men
and that of producing one unit of groundnut is 9 men. It is clear that the cost of producing
groundnut is more than that of cocoa because one unit of cocoa can exchange for 0.89
unit of groundnut.

Suppose trade begins between the two countries. Nigeria will gain if it imports one unit
of cocoa from Ghana in exchange for less than 1.2 units of groundnut. Ghana will also
gain if it imports one unit of groundnut from Nigeria in exchange for more than 0.89 unit
of cocoa.

Domestic Exchange Ratios

Nigeria Ghana

Cocoa 12: 10 Groundnut (6/5) Cocoa 8: 9Groundnut (8/9)

1: 1.2 1: 0.89

Groundnut 10: 12Cocoa (5/6) Groundnut 9: 8Cocoa (9/8)

1: 0.83 1: 1.13

From the domestic exchange ratio in Nigeria is one unit of groundnut = 0.83 unit of
cocoa, and in Ghanaone unit of cocoa = 0.89 unit of groundnut. If we assume the
exchange ratio between the two countries to be 1 unit of groundnut = 1 unit of cocoa,
Nigeria would gain 0.17 (1 – 0.83) unit of cocoa by exporting one unit of groundnut to
Ghana. Similarly, the gain to Ghana by exporting one unit of cocoa to Nigeria will be
0.11 (1 – 0.89) unit of groundnut. Thus, trade is beneficial for both countries.

In summary, both Nigeria and Ghana specialize in the production of one commodity on
the basis of comparative costs. Each reallocates its factors accordingly and exports that
commodity in which it has comparative advantage and imports that commodity in which
it has a comparative disadvantage. Both gain through trade and can increase the
consumption of the two commodities.
Self Assessment exercise:
Discuss the explanation and gains from trade of comparative advantage theory.
3.3 Criticisms of Ricardo’s Comparative Advantage Theory
Although, the principle of comparative advantage has been the very basis of
international trade for over a century until after the First World War, it has been
criticised in a several ways:
1. The assumption of labour cost isunrealistic: This is the most severe criticism of
the comparative advantage doctrine because it is based on the labour theory of value. In
calculating production costs, it takes only labour costs and neglects non-labour costs
involved in the production of commodities. This is unrealistic because it is money costs
and not labour costs that are the basis of national and international transactions of goods.
Also, the labour cost theory is based on the assumptions of homogenous labour butthis
not viable because labour is heterogeneous of different kinds and grades, some specific
or specialized, and other non-specific or general.

2. No similar tastes: The assumption of similar tastes is impractical because tastes

differ with different income brackets in a country. Moreover, they also change with the
growth on an economy and with the development of its trade relations with other
countries.

3. Assumption of labour in fixed proportions: This theory is based on the assumption

that labour is used in the same fixed proportions in the production of all commodities.
This is essentially a static analysis and hence unrealistic. As matter of fact, labour is
used in varying proportions in the production of commodities. For instance, less labour
is used per unit of capital in the production of textiles. Moreover, some substitution of
labour for capital is always possible in production.

4. Unrealistic assumptions of constant costs: The theory is based on another

assumption that an increase of output due to international specialization is followed by
constant costs, but the fact is that there are either increasing costs or diminishing costs. If
large scale of production reduces costs, the comparative advantage will be increased. On
the other hand, if increased output is the result of increased cost of production, the
comparative advantage will be reduced, and in some cases it may even disappear.

5. The theory ignores transport costs: Ricardo ignores transport costs in determining
comparative advantage in trade. This is unrealistic because transport costs play an
important role in determining the pattern of world trade. Like economies of scale, it is an
independent factor of production. For instance, high transport costs may nullify the
comparative advantage and the gain from international trade.

6. Factors not fullymobile internally: The doctrine assumes that factors of production
are perfectly mobile internally and completely immobile internationally. This is not
realistic because even within a country factors do not move freely from one industry to
another or from one region to another. The greater the degree of specialization in an
industry, the less is the factor mobility from one industry to another. Thus, factory
mobility influences costs and thus the pattern of international trade.

7. The assumption of two-country, two-commodity model is impracticable: The

Ricardian theory is related to trade between two countries on the basis of two
commodities. This is again unrealistic because in reality, international trade is among
many countries trading in many commodities.
8. Impractical assumption of free trade: Another serious weakness of the doctrine is
that it assumes perfect and free world trade. But, in reality, world trade is not free. Every
country applies restrictions on the free movement of goods to and from other countries.
Thus, tariffs and other trade restrictions affect world imports and exports. Moreover,
products are not homogeneous but differentiated.

9. Unrealistic assumptions of full employment: Like all classic theories, the theory of
comparative advantage is based on the assumption of full employment. This assumption
also makes the theory static. Keynes gives the assumption of full employment and
proved the existence of under-employment in an economy. Thus, the assumption of full
employment makes the theory unrealistic.

10. Self-interest hinders its operation:The doctrine does not operate if a country
having a comparative advantage does not wish to import a commodity from other
country due to strategic, military or development considerations. As a result, self-interest
stands in the operation of the theory of comparative costs advantage.
11. Neglects the role of technology: The theory neglects the role of technological
innovations in international trade. This is unrealistic because technological changes help
in increasing the supply of goods not only for the domestic market but also international
market. World trade has gained much from innovations and research and development (R
& D).
12. One-sided theory: The Ricardian theory is one-sided because it considers only the
supply side of international trade and neglects the demand side.

13. Impossibility of complete specialization: Prof. Frank Graham has pointed out that
complete specialization will be impossible on the basis of comparative advantage in
producing commodities entering into international trade. He explains two cases in
support of his argument: one, relating to a big country and a small country; and two,
relating to a commodity of high value and low value.
To take the first case, suppose there are two countries which enter into trade on the basis
of comparative advantage. Of these, one is big and the other is small. The country will
be able to specialize completely as it can dispose of its surplus commodity to the bigger
one. But the big country will not be able to specialize fully because (a) being big, the
small country will not be in a position to meet its requirements fully, and (b) if it
specializes completely in a particular commodity, its surplus will be so large that the
smaller country will not be able to import the whole of it.
In the second case of commodities having incomparable value, the country producing
high value commodity will be able to specialize while that producing low value
commodity will not be able to do the same. This is because the former country will be in
a position to have a larger gain than the latter country. Thus, according to Graham, “The
classical conclusion of complete specialization between two countries can hold ground
only by assuming trade between two countries of approximately equal economic
performance.”
14. Prof. Ohlin has criticized the theory of international trade on the following grounds:
i. The principle of comparative advantage is not applicable to international trade
alone; rather it is applicable to all trade. To Ohlin international trade is but a
special case of inter-regional trade. Thus there is little difference between internal
trade and international trade.
ii. Factors are immobile not only internationally but also within different regions. This
is proved by the fact that wages and interest rates differ in different regions of the
same country. Further, labour and capital can also move between countries in a
limited way, as they do within a region.
iii. It is a two-country, two-commodity model based on the labour theory of value
which is sought to be applied to actual conditions involving many countries and
many commodities. He therefore, regards the theory of comparative advantage as
cumbersome, unrealistic, and as a clumsy and dangerous theory tool of analysis.
As an alternative, Ohlin has propounded a new theory which is known as the
modern theory of International Trade.
Self Assessment exercise:
What are the criticisms of comparative advantage theory?
4.0 Conclusion
Despite the short comings of the comparative cost advantage trade theory, it has stood the
test of the times. Its basic structure has remained intact, even though many refinements
have been made over it. Also, the underlying principle of comparative advantage can still
be said to give some ‘shape’ to the pattern of world trade, even if it is becoming less
relevant in a globalised world and in the face of modern theories.
5.0 Summary

The theory of comparative advantage is an economic theory about the work gains from
trade for individuals, firms, or nations that arise from differences in their factor
endowments or technological progress.In an economic model, agents have a comparative
advantage over others in producing a particular good if they can produce that good at a
lower relative opportunity cost or autarky price, i.e. at a lower relative marginal cost prior
to trade. One does not compare the monetary costs of production or even the resource
costs (labour needed per unit of output) of production. Instead, one must compare the
opportunity costs of producing goods across countries. The closely related principle of
comparative advantage holds that under free trade, an agent will produce more of and
consume less of a good for which they have a comparative advantage.
6.0 Tutor-Marked Assignment
a. The Ricardian comparative cost advantage was a development over the Adam
Smith’s absolute cost advantage. Discuss
b. The comparative cost advantage resulted to advancement of Classical thought.
Discuss
c. Compare and contrast the two trade theory of the classists
d. What are the major pitfall of comparative cost advantage..
7.0 References/Further Readings
Amacher, R & Ulbrich, H, (1986); Principles of Economics, South Western Publications
Co. Cincinnafi, Oliso.

Arnold Kling (2012). The Concise encyclopaedia of economics, international trade

library of economy liberty.

Familoni K.A, (1990); Development in Macroeconomics Policy, Concept Publications,

Lagos, Nigeria

Jhingan M.L, (2010); International Economics, 6th edition, Vrinda Publications (P)
Ltd. Delhi, India

Jhingan M.L, (2010); Macroeconomics Theory, 12th edition, Vrinda Publications (P)
Ltd. Delhi, India

Krugman Obstfeld, (1975); International Economics Theory and Policy, 8th edition
Pearson International edition,.

Olasupo Akano (1995); International trade theory and evidence, Rebonik publication Ltd,
lagos,

Feentra Robert C. (2004). Advanced International Trade Theory and Evidence, Princeton,
New Jersey, Princeton University Press.
 MODULE FIVE
MODERN THEORY OF INTERNATIONAL TRADE
Unit 1: The Heckscher-Ohlin theory
Unit 2: Samuelson’s Factor Price Equalisation Theorem
Unit 3: Factor Intensity Reversal

UNIT 1: THE HECKSCHER-OHLIN THEORY

CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Meaning and Assumptions of the Heckscher-Ohlin Theory
3.2 Explanation of Heckscher-Ohlin Theory
3.3 The Supremacy of Heckscher-Ohlin Theory over the Classical Theory
3.4 Criticisms of Heckscher-Ohlin Theory
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Readings

1.0 Introduction

The modern theory of international trade has been advocated by Bertil Ohlin. Ohlin has
drawn his ideas from his teacher; Heckscher's General Equilibrium Analysis. Hence it is
also known as Heckscher Ohlin (H-O) Model / Theorem / Theory. According to Bertil
Ohlin, trade arises due to the differences in the relative prices of different goods in
different countries. The difference in commodity price is due to the difference in factor
prices (i.e. costs). Factor prices differ because endowments (i.e. capital and labour) differ
in countries. Therefore, trade occurs because different countries have different factor
endowments

2.0Objective
At the end of this unit student should be able to
• Understand the meaning of Heckscher-Ohlin theory
• Explain the underlining assumptions of the theory
• Understand the explanation of the theory
• Know why the Heckscher-Ohlin theory is different from Ricardo trade theory
• Explain the criticisms of the theory
3.0 Main Content
3.1Meaning and Assumptions of the Heckscher-Ohlin Theory
Heckscher-Ohlin (H-O) theory said that the main determinant of the pattern of
production, specialisation and trade among regions is the relative availability of factor
endowments and factors prices. Countries have differentfactor endowments and factor
prices that is some countries have much capital, others have much labour. The theory
says that countries that are rich in capital will export capital-intensive goods and
countries that have much labour will export labour-intensive goods. For Ohlin, the
immediate cause of international trade is that some commodities can be bought more
cheaply from other countries, whereas in a country the production will beat high prices.
Therefore, the main cause of trade between countries is the difference in price of
commodities based on relative factor endowments and factor prices.

Assumptions of Heckscher-Ohlin's (H-O) Theory

Heckscher-Ohlin's theory explains the modern approach to international trade on the

basis of following assumptions:

1. There are two countries involved.

2. Each country has two factors (labour and capital).
3. Each country produce two commodities or goods (labour intensive and capital
intensive).
4. There is perfect competition in both commodity and factor markets.
5. All production functions are homogeneous of the first degree i.e. production
function is subject to constant returns to scale.
6. Factors are freely mobile within a country but immobile between countries.
7. Two countries differ in factor supply.
8. Each commodity differs in factor intensity.
9. The production function remains the same in different countries for the same
commodity. For e.g. If a commodity requires more capital in one country then
same is the case in other country.
10. There is full employment of resources in both countries and demands are identical
in both countries.
11. Trade is free i.e. there are no trade restrictions in the form of tariffs or non-tariff
barriers.
12. There are no transportation costs.

Given these assumptions, Ohlin's theory contends that a country export goods which use
relatively a greater proportion of its abundant and cheap factor. While same country
imports goods whose production requires the intensive use of the nation's relatively
scarce and expensive factor.

Self Assessment exercise:

 What is the opinion and assumptions of Hecksher-Ohlin to international trade?
3.2 Explanation of Heckscher-Ohlin Theory
Subject to the assumptions, Heckscher-Ohlin theory contends that the immediate cause of
international trade is the difference in relative commodity prices caused by differences in
relative demand and supply of factors (factors price) as a result of differences in factor
endowments between the two countries. Basically, the relative scarcity of factors the
shortage of supply in relation to demand is essential for trade between two regions.
Commodities which use large quantities of scarce factors are imported because their
prices are high while those using abundant factors are exported because their prices are
low.
The H-Otheory is explained in terms of two definitions: (1) factor abundance (or scarcity)
in terms of the price criterion; and (2) factor abundance (or scarcity) in terms of physical
criterion.
Factor Abundance in Terms of Factor Prices:Heckscher-Ohlin explains fortune in factor
endowment in terms of factor prices. That is, countryA is abundant in capital if
(Pc/PL)A<(Pc/PL)B, where PC and PL refer to prices of capital and labour, and the A and B
subscript denote the two countries. In other words, if capital is relatively cheap in country
A, the country is abundant in capital, and if labour is relatively cheap in country B, the
country is abundant in labour. Therefore, country A will produce and export the capital-
intensive good and import the labour-intensive good and country B will produce and
export the labour-intensive good and import the capital intensive goods. This is illustrated
in Figure 5.1.1 below.
Y
A
B
C E X
K G
B1 Y

M L

T S
Capital

X
O D H R A1 B2 B3
N
Labour
Figure 5.1.1Factor Abundance in Terms of Factor Prices
From the diagram, X is the labour-intensive commodity taken on the horizontal axis and
Y is the capital-intensive commodity taken on the vertical axis. XX is the isoquant of
commodity X and YY is that of commodity Y and this is the same for both countries. The
relative factor prices in country A for both the commodities are given by the factor price
line AA1. Let assume that each isoquant represents one unit of the respective commodity
then 1 unit of Y will be produced with OC amount of capital and OD amount of labour at
point E where the factor price line AA1 is tangent to the isoquant YY. In the same view,
the cost of producing one unit of commodity X in country A is OM amount of capital and
ON amount of labour. Since capital is abundant and cheap in country A, it will specialize
in the production of the capital-intensive commodity Y that is in order to produce 1 units
of Y it uses more amount of capital OC with OD of labour at point E on the isoquant YY.
While at point L on the isoquant XX, it uses less amount of capital OM with more of
labour ON in order to produce 1 unit of X. Hence country A will produce and export the
relatively capital abundant and cheap commodity Y to the other country B.
In order to find the cost of producing one unit of each commodity in country B where
labour is relatively cheap and abundant, we draw a flatter factor price line BB3 tangent to
the isoquant YY at point G. A similar factor price line B1B2 is drawn parallel to BB3
which is tangent to the isoquant XX at point S. Now it requires OK amount of capital and
OH amount of labour to produce one unit of commodity Y in country B, and OT amount
of capital and OR amount of labour to produce one unit of commodity X in this country.
Since labour is cheap and abundant in country B, it will specialize in the production of
labour-intensive commodity X. So it will produce commodity X at point S on the
isoquant XX, which requires more amount of labour OR with less amount of capital OT
than commodity Y which requires less amount of labour OH with more amount of capital
OK at point G on the isoquant YY. Thus, country B will export commodity X to country
A in exchange for commodity Y.
This establishes the H-O theory that the capital abundant country will export the
relatively cheap capital-intensive commodity, and the labour abundant country will
export the relatively cheap labour-intensive commodity.
Factor Abundance in Physical Terms: The H-O theory is also explained in physical
terms of factor abundance. For this principle, a country is relatively capital abundant if it
is endowed with a higher proportion of capital and labour than the other country. If
country A is relatively capital-abundant and country B is relatively labour-abundant,
when measured in physical amounts CA/LA> CB/LB, where CA and LA are the total
amounts of capital and labour respectively in country A, and CBand LAare the total
amounts of capital and labour respectively in country B. From the Figure 5.1.2 below, the
production possibility curve of country A is AA1 and that of country B is BB1. The slopes
of these two curves show that commodity Y is capital intensive and commodity X is
labour intensive. If countries A and B produce both commodities in the same proportion,
they will produce along the ray OR. When both produce at their respective points,
country A will produce at point E where the factor-price line ST touches the production
productivity curve AA1. It will produce more of commodity Y (that is OS) which is
 S

A
R
K
Y-Commodity

E
B
F

O A1 B1 T R
X-Commodity
Figure 5.1.2Factor Abundance in Physical Terms
cheaper in it and less (OT) of commodity X which is costly in the country. Country B
will produce at point F where the factor price line KR touches the production possibility
curve BB1. It will produce more (OR) of commodity Y which is also costly in country B.
This can be proved by the slope of the factor-price line ST of country A which is steeper
than the factor-price line KR of country B which is flatter:
that is Slope of KR > Slope of ST.
𝑃𝑃𝑥𝑥 𝑃𝑃𝑥𝑥
� � >� �
𝑃𝑃𝑦𝑦 𝐴𝐴 𝑃𝑃𝑦𝑦
𝐵𝐵

The difference between both factor-price lines TR on X-axis indicates that OR of

commodity X is produced more in country B relatively to OT quantity of X in country A.
Similarly, the difference between both factor price lines KS on Y-axis shows that OS of
commodity Y is produced more in country A relatively to OK quantity of Y in country B.
Thus the capital-abundant country A as bias in favour of capital-intensive commodity Y
from the production side, and the labour abundant country B have a bias in favour of
producing the labour-intensive commodity X. But the above analysis of physical terms
does not show that the capital-abundant country will export the capital-intensive
commodity Y and the labour-abundant country will export the 1abour-intensive
commodity X.

Self Assessment exercise:

Differentiate between the H-O theory of factor abundance in terms of factor prices and
factor abundance in physical terms.
3.3The Supremacy of Heckscher-Ohlin Theory over the Classical Theory

The Heckscher-Ohin theory of international trade differs from the classical comparative
cost theory in many ways and is also superior to the latter. It is also an improvement over
the classical theory of international trade

(i) According to the classical economists, there was need for a separate theory of
international trade because international trade was fundamentally different from internal
trade. Heckscher and Ohlin, on the other hand, felt that there was no need for a separate
theory of international trade because international trade was similar to internal trade. The
difference between the, two was one of degree, and not of kind.

(ii) The classical economists explained the phenomenon of international trade in terms of
the old, discredited labour theory of value. The modern theory explained international
trade in terms of the general equilibrium theory of value.

(iii) The classical theory attributes the differences in the comparative advantage of
producing commodities in two countries to the differences in the productive efficiency of
workers in the country. The modern theory attributes the differences in the comparative
advantage to the differences in factor endowments.

(iv) The classical theory presents a one-factor (labour) model, while the modern theory
presents a more realistic multi-factor (labour and capital) model.

(v)The classical theory never took into account the factor price differences, while the
modern theory considers factor price differences as the main .cause of commodity price
differences, which, in turn, provides the basis of international trade,

(vi) The classical theory does not provide the cause of differences in comparative
advantage. The modern theory explains the differences in comparative advantage in terms
of differences in factor endowments.

(vii) The classical theory is a single market theory of value, while the modern theory
emphasizes the importance of space element in international trade and involves a multi-
market theory of value.

(viii) The classical theory is a normative or welfare-oriented theory, .whereas the modern
theory, is a positive theory. The classical theory tries to demonstrate the gains from
international trade, while the; moderntheory concentrates on the basis of trade.

(ix) The main cause of the international trade is the difference in factor supplies between
the countries. Each country differs in factor endowments i.e. in their abundance or
scarcity. Difference in supply, given the demand, brings the difference in cost of factor
 and finally, the difference in commodity prices. In Ricardian theory, difference in factor
(labour) efficiency is recognized but difference in factor supply is ignored. H.O. theory,
therefore provides a better explanation of price difference of factors through the
difference is their supplies.

(x) Ricardian theory which no doubt explains the reason for internal trade is more
concerned with the benefits of trade. For classical economists, the welfare aspect of trade
is more important. Ohlin has adapted a positive approach in explaining the cause of
international trade. His main concern was to find out the cause of trade and not so much
of its welfare aspect. Therefore, it is pointed out that Ohlin's analysis has contributed to
positive economic analysis.

(xi) The H-O model is more realistic than the classical theory in that the former leads to
complete specialisation in the production of one commodity by one country and of the
other commodity by the second country when they enter into trade with each other. By
contrast, the trade between two countries may or may not lead to complete specialisation
in the classical theory.

(xii) According to Lancaster, the H-O theory is superior to the classical theory because it
refers to the future of trade. In the classical theory, differences in comparative costs
between two countries are due to differences in the efficiency of labour. If, in future,
labour becomes equally efficient in both the countries, there will be no trade between
them. But in the H-O theory trade will not cease even if labour becomes equally efficient
in the two countries because the basis of trade is differences in factor endowments and
prices.

Self Assessment exercise:

Critically differentiate between the classical theory of international trade and the H-O
theory of international trade.

3.4 Criticisms of Heckscher-Ohlin Theory

Heckscher Ohlin's theory has been criticised on basis of following grounds :-

1. Unrealistic Assumptions: Aside of the usual assumptions of two countries, two

commodities, no transport cost, etc. H-O theory also assumes no qualitative difference
in factors of production, identical production function, constant return to scale, etc.
All these assumptions makes the theory unrealistic one.
2. Restricted: H-O theory is not free from constrains because this theory includes only
two commodities, two countries and two factors. Thus it is a restricted one.
3. One-Sided Theory: Also to Heckscher-Ohlin's theory, supply plays a significant role
than demand in determining factor prices. But if demand forces are more significant, a
 capital abundant country will export labour intensive good as the price of capital will
be high due to high demand for capital.
4. Static in Nature: Like Ricardian Theory the H-O Model is also static in nature. The
theory is based on a given state of economy and with a given production function and
does not accept any change.
5. Tastes and Demand Patterns not Identical: The H-O theory is based on the
assumption of identical tastes and demand patterns of consumption in both countries.
This means that the tastes and demand patterns of consumers are the same for
different income groups but this is unrealistic. More so, with inventions taking place
in consumers’ goods, changes in tastes and demand patterns of consumers also occur
even among developed countries. As a result, tastes are not identical in trading
countries.
6. Consumers' Demand is ignored: H-O theory did not mentioned an important fact
that commodity prices are also influenced by the consumers' demand.
7. Haberler's Criticism : According to Prof. Haberler, Ohlin's theory is based on partial
equilibrium. It fails to give a complete, comprehensive and general equilibrium
analysis.
8. Leontief Paradox:Ohlin assumes that relative factor prices reflect exactly relative
factor endowments. It implies that in the determination of factor prices, supply is
more important than demand. If, however, the demand factors are given more
importance in determining factor prices, a capital-rich country will export a labour-
intensive commodity because the high demand for capital will raise the price of
capital relative of labour. Prof. Leontief’s empirical study of the Ohlin theorem,
known as the Leontief Paradox, has led to paradoxical results that the United States
exports labour-intensive goods and imports capital-intensive goods, even though it is
a capital-rich country.
9. Other Factors Neglected: Factor endowment is not the sole factor influencing
commodity price and international trade. The H-O Theory neglects other factors like
technology, technique of production, natural factors, different qualities of labour, etc.,
which can also influence the international trade.
10. Factor Prices do not determine Commodity Prices: Wijanholds has criticised Ohlin
for his view that commodity prices are determined by the factor prices which in turn,
determine costs. He holds that the prices of commodities are determined by their
utility to the consumers, and that the prices of raw materials and labour are ultimately
dependent on t1ie prices of the final commodities. He maintains that the right
approach is to start with commodity prices rather than factor prices.
11. Transport Costs influence Trade: The theory does not consider transport costs in
trade between two countries, because beside transport costs, loading and unloading of
goods and other port charges affect the prices of produced commodities in the two
countries. When transport costs are included, it will lead to price differential for the
same commodity in the two countries which will affect their trade relations.
12. Unrealistic Assumptions of Full Employment and Perfect Competition: Even
though, the H-O theory isbased on the assumptions of full employment and perfect
 competition there is neither full employment nor perfect competition in any country of
the world. Rather, countries do not have free trade but impose trade restrictions on a
large scale.

Self Assessment exercise:

Critically explain the Heckscher-Ohin theory of international trade.

4.0 Conclusion
The Heckscher-Ohlin's theory concludes that:
1. The basis of international trade is the difference in commodity prices in the two
countries.
2. Differences in the commodity prices are due to cost differences which are the results
of differences in factor endowments in two countries.
3. A capital rich country specialises in capital intensive goods and exports them. While a
labour abundant country specialises in labour intensive goods and exports them.

5.0 Summary

This unit discussed the Heckscher-Ohlin trade theory and emphasized on its supremacy
over the classical absolute andcomparative cost advantage trade theory not refuting the
fact that both theories are very important to the study of international trade in
economics.The unit therefore established in clarity the basic theoretical fact about its (H-
O) supremacy over the classical school’s cost advantages. Furthermore, the explanation
about the workability of theory was given in details to the understanding of the students
and thus, ended with a number of criticisms from other group of economists that could
provoke further research..

6.0 Tutor-Marked Assignment

a. Critically examine the view that international trade will results from differences in
factor endowments in countries.
b. Critically discuss the modern theory of international trade.
c. To what extent is Heckscher-Ohlin theory of international trade superior to the
classical theory of international trade?
d. Explain the Heckscher-Ohlin theory of international trade and the assumptions
underlying it.
7.0 References/Further Readings
Arnold Kling (2012) ; the coincise encyclopaedia of economics, international trade
library of economy liberty.
Jhingan M.L, (2010); International Economics, 6th edition, Vrinda Publications (P)
Ltd. Delhi, India

Jhingan M.L, (2010); Macroeconomics Theory, 12th edition, Vrinda Publications (P)
Ltd. Delhi, India

Krugman Obstfeld, (1975); International Economics Theory and Policy, 8th edition
Pearson International edition,.

Olasupo Akano (1995); International trade theory and evidence, Rebonik publication Ltd,
Lagos.
UNIT 2:SAMUELSON’S FACTOR PRICE EQUALISATION THEOREM
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Meaning and Assumptions of Factor Price Equalisation Theorem
3.2 Explanation of the working of the theorem
3.3 Criticismsof Samuelson’s Factor Price Equalisation Theorem
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Readings

1.0 Introduction

The factor-price equalisation theorem is an important corollary derived from the

Heckscher-Ohlin factor-proportions analysis.Having explained the meaning of
comparative price advantages as the basis of international trade, Ohlin proceeds to
analyse the effects of international trade on factor prices in a general equilibrium system.
The theorem of factor-price equalisation thus contends that: fundamentally, international
trade in commodities acts as a substitute of the mobility of factors between countries.
When the factors of production are completely immobile internationally, but goods are
freely exchanged between countries, then the prices of these factors tend to become equal
(both relatively and absolutely) in the countries concerned.

2.0Objective
At the end of this unit student should be able to
• Understand the meaning of factor price equalisation
• Know the assumptions given for the working of the theorem
• Understand the explanation of the factor price equalisation theorem
• Explain the criticisms of the theorem
3.0 Main Content
3.1 Meaning and Assumptions of Factor Price Equalisation Theorem

Factor price equalization is an economic theory and was propounded by Paul A.

Samuelson in 1948, and the theorem states that the prices of identical factors of
production, such as the wage rate, or the rent of capital, will be equalized across countries
as a result of international trade in commodities. The theorem assumes that there are two
goods and two factors of production, for example capital and labour. Other key
assumptions of the theorem are that each country faces the same commodity prices,
because of free trade in commodities, uses the same technology for production, and
produces both goods. Significantly these assumptions result in factor prices being
equalized across countries without the need for factor mobility, such as migration of
labour or capital flows. Any factor which receives the lowest price before two countries
integrate economically and effectively become one market will therefore tend to become
more expensive relative to other factors in the economy, while those with the highest
price will tend to become cheaper.

Factor-price equalisation theorem is based on the following assumptions:

(i) There are two countries producing and trading in two commodities

(ii) There are quantitative differences of factors in different regions, no qualitative

differences.

(iii) Production functions of different products are different, requiring different

proportions of different factors in producing different goods.

(iv) There is perfect competition in the commodity markets as well as in the factor
markets in all the regions.

(v) There are no restrictions on trade, that is, free trade policy is followed by all the
countries.

(vi) The consumer’s preferences as well as the demand patterns and positions are
unchanged.

(vii) There are stable economic and fiscal policies in the participating nations.

(viii) The transport cost element is ignored.

(ix) Technological progress in different regions is identical.

(x) There are constant returns to scales in each region.

(xi) There is perfect mobility of factors.

(xii) There is tendency towards complete specialisation.

Under these assumptions only the theorem holds that free trade between countries tends
to reduce the original factor price inequality and a state of complete specialisation in
effect leads to complete factor price equality.
Self Assessment exercise:

What do you understand by Samuelson’s factor price equalisation theorem?

3.2 Explanation of the working of the theorem

Given the assumptions, real factor prices must be exactly the same in both countries and
the proportion of inputs used in food and clothing production in both Nigeria and Ghana
must be equal. Samuelson proof the theorem by assuming perfect competition, that the
ratio of the price of food to clothing in each country will be equal to the ratio in each
country of the marginal cost of producing food to the marginal cost of manufacturing
clothing. Also, there is one price food and clothing in the two countries, because it is
assumed that trade is free and unrestricted and there are no transport costs.

Since prices reflect marginal costs, and prices are equal in the two countries therefore
marginal costs is also equal. Hence, the marginal cost of producing food and clothing in
Nigeria and Ghana are the same. If identical production functions are assumed, the
marginal productivity of labour will be the same in the two countries makingwages to be
equal. This is also applicable to the other factor, land. Therefore, free trade will equalise
not only commodity prices, but also factor prices, so that all labourers will earn the same
wage rate and all units of land will earn the samerental return in both countries.

Testing Samuelson’s intuitive proof, let presume that the wage rate is lower in Ghana
than in Nigeria. Since cost isentirely determined by factor prices, the cost of labour-
intensive clothing in Ghana would be lower this will increase the demand for clothing in
Nigeria. As the production of clothing expands, it raises wages relative to the rent of land.
An increase in the ratio of wages to rent must in a competitive market push up the price
of labour-intensive clothing relatively to land-intensive food in Ghana. Likewise, the
import of land-intensive food from Nigeria will reduce the scarcity and the ratio of wages
to rent of the food industry in Ghana. This also applies to the production of food and
clothing in Nigeria.

The factor-price equalization theorem is further illustrated slightly by Prof. Lerner in Fig.
5.2.1 below.FF is the isoquant for food and CC is the isoquant for clothing. They
represent the production functions of the two commodities in both countries. Rays OR
and OS form what Chipman calls the ‘cone of diversification’ which is ROS in the figure
5.2.1. Assuming that the after-trade factor-price ratio for the two commodities in Nigeria
and Ghana is represented by the line PL, it is tangent to the isoquant F at R and to the
isoquant CC at S. if the pre-trade relative factor-prices of food and clothing in Nigeria are
indicated by the slope of the dotted line PNLN which is tangent to the isoquant FF at point
K. To form the endowment ray OK. Since the endowment ray OK lies outside the cone
ROS, Nigeria will completely specialised in the production of land-intensive food, but
factor-prices will not be equalised, hence, the land/labour ratio of producing a unit of
food is high and the cost of production is also high. This is because the marginal
productivity (MPF) of land in value terms is lower than its rent, and the marginal
productivity of labour value terms is higher than its wage. Therefore, Nigerian domestic
factor-price ratios are inconsistent with after-trade factor-price ratios of food and
clothing. Itis only by using relatively more labour less land at point R, on the
international price line PL than at K on the line PNLN that the marginal productivity of
land equals its rent.

F
PN
K
P

R C
Land

PG S

T C

O LN L LG
Labour

Figure 5.2.1 Factor Price Equalisation

Assuming the domestic factor price ratios of the two commodities in Ghana are
represented by slope of the dotted line PGLG which is tangent to the isoquant CC at T to
form the endowment ray OT. Since this endowment ray also lies outside the cone ROS in
the figure 5.2.1, Ghana willtotally specialised in production of labour-intensive clothing.
Also factor prices will not equalised because clothing is labour-intensive, therefore the
marginal productivity (MPC) of labour in value terms is lower than its wage and marginal
productivity of land (MPF) is higher than its rent. Consequently the domestic price ratios
of producing clothing and food in Ghana are not in agreement with the after-trade factor
price ratios of the two commodities Thus, by employing relatively less labour and more
land at point S on the international price line PL than at T on the line PGLG that the
marginal productivity of labour equals its wage.
Therefore by using OR land/labour ratio in the production of food and OS land/labour
ratio in the production of clothing, the factor prices are equalised in Nigeria and Ghana at
the international price ratio given by slope of the PL line. At points R and S, the
land/labour ratio equals the slopes of the lines OR and OS. The marginal products of land
and labour for clothing associated with equilibrium point S are 1/OP and I/OL and the
same goes for food. The price of clothing at point S = Wage x OL = Rent x OP. The same
is price for food at point R = Wage x OL = Rent x OP. Thus factor prices of both
commodities are equalized.

Self Assessment exercise:

Give a detail analysis of the Samuelson’s factor price equalisation theorem?

3.3 Criticisms of Samuelson’s Factor Price Equalisation Theorem

This theorem has been criticized by some economistsand among them is Meade,
Ellsworth and their criticisms are base on the restrictive assumptions of the theorem.
They argue that factor-price equalization can be partial and not absolute for the following
reasons:

1. TwoFactors of Production not Available: It is assumed that the two factors of

production are available in the two countries. But it is possible that only one factor
is available in one country. Subsequently, the marginal productivities of the factor
common to both countries will differ and its prices cannot be equalized in the two
countries.

2. Production Function not the same in the Countries: The theorem also assumes
that production functions are the same in the two countries. But, production
functions are never identical. Even if resources are the same in both countries,
they would not necessarily produce the same commodity with their resources. As
pointed out by Meade, “The same text-books and the same brains would not
produce the same thoughts in Chicago and London.” This is because physical
climate and social and intellectual atmosphere for the production of commodities
differ from country to country.

3. Transport Costs is not Considered: The assumption of absence of transport

costs is impractical because costs is always incurred when sending commodities
from one country to the other. This will make the price of food to be higher in
Ghana than in Nigeria, and the price of clothing will be higher in Nigeria than in
Ghana. As a result, the marginal product of labour and the wage rate will be lower
in Ghana than in Nigeria and the same goes for the marginal product of land and
the rent which will be lower in Nigeria than in Ghana. Hence, factor price
equalisation becomes impossible .
4. Factor-Price Equalisation not Possible under Constant Costs:The Samuelson
theorem is based on the assumption of constant returns to scale. Meade has
established that if there are economies of production in the manufacture of the
commodities, factor price equalisation will not be possible. If Ghana enjoys more
economies of large scale production in the manufacture of clothing than Nigeria,
the marginal productivity of labour would be higher in Ghana and lower in
Nigeria. Even though commoditiesprices are the same in the two countries, but
factor prices would be different.

Also, if there is increasing returns, the theorem will not work because increasing
returns and perfect competition are incompatible. Moreover, under increasing
returns each factor would be paid less than its marginal productivity and the total
product would be more than exhausted.

5. Specialisation in One Commodity Possible: It is further assumed that no country

specializes completely in the production of a single commodity. But there is
everychance that one of the countries specialises in the production of one
commodity before the application offactor-price equalisation. This will be so if the
other industry, say wheat in Ghana, happens to be very small in relation to the
specialize industry, clothing. In this situation, factor price equalisation will not
take place till all factors engaged in the wheat production move to the other
country, Nigeria.

6. Not Applicable to More than Two Goods and Factors: The factor-price
equalisation theorem is based on the two-commodity and two-factor assumptions.
If the number of factors of production is more than the number of commodities,
the theorem would collapse.

7. Static Theory: The Samuelson theorem is a completely static theory. It only

studies some characteristics of a given equilibrium situation at a given point in
time. It says only what the effects of trade will be with a given technique, with
given factor endowments, and so on. But the real world is not in a
givenequilibrium forever; different changes occur.

8. Inequalities in Factor Incomes: Myrdal, Kindleberger, Sodersten, and others

believed that in the world there are increasing inequalities in factor incomes rather
than equalities in them. According to Myrdal, a cumulative process away from
equilibrium in factor proportions and factor prices engendered technological trade
has been taking place. Kindleberger is more definite when he writes that “trade
between developed and less developed countries widens the gap in living
standards (and factor prices such as wage) rather than narrows it, and it is evident
after centuries of trade that there are still poor as well as rich countries.
9. Non-existence of Perfect Competition: The Samuelson theorem is based on the
unrealistic assumption of perfect competition in international trade without any
tariff and non-tariff barriers. In reality, trade barrier do exist which make complete
equalisation of factor prices impossible.

10. Factor Intensity Reversal: The Samuelson theorem is based on the assumption
that the production functions differ in factor intensities. It implies that the
production functions have constant substitution elasticities so that each production
function can be identified as being relatively land (or capital)- intensive or labour-
intensive at all relevant points on the two production functions. But it is possible
that the production functions do not have the same elasticities of substitution. One
point on the production function may be relatively land (or capital)-intensive and
another point on the same production function relatively labour-intensive. This is
the case of factor intensity reversals where a one-to-one correspondence between
factor prices and factor intensities is not possible.

Self Assessment exercise:

What are the criticisms of the Samuelson’s factor price equalisation theorem?

4.0 Conclusion
The Samuelson’s factor price equalization theorem concludes that the basis of
international trade is the difference in factor prices in the two countries and that engaging
in international tradecould bring the factor rewards close or same between the trading
partners, but these factors must be identical among other assumptions.

5.0 Summary

This unit discussed the Samuelson’s factor price equalization theorem which was
considered to be an improvement over the Hechscher-Ohlin trade theory which was built
on the premise that returns to identical factor input would be equalised if trade exist
between two or more countries, also that if they trade in common commodities assuming
constant return to scale. Samuelson was able to established his fact by laying some
fundamental assumption which was well discussed in thus unit, in addition its pitfalls
were also analysed to pave room for further research..

6.0 Tutor-Marked Assignment

a. Critically examine the view that international trade will resolve differences in
factor’s reward among the trading countries.
b. Critically discuss major assumptions of Samuelson’s factor price equalization
theorem.
c. In one statement, summarise Paul Samuelson’s contribution to international trade
theory.
d. List and explain major criticisms of factor price equalization theorem.
7.0 References/Further Readings
Jhingan M.L, (2010); International Economics, 6th edition, Vrinda Publications (P)
Ltd. Delhi, India

Jhingan M.L, (2010); Macroeconomics Theory, 12th edition, Vrinda Publications (P)
Ltd. Delhi, India

Krugman Obstfeld, (1975); International Economics Theory and Policy, 8th edition
Pearson International edition,.

Olasupo Akano (1995); International trade theory and evidence, Rebonik publication Ltd,
lagos.

Krugman Paul, Obstfeld Maurice (2007). Resources and Trade: The Heckscher-Ohlin
Model. International Economics: Theory and Policy. Boston, Addison Wesley. pp. 67–
92.

RybczynskiTadeusz (1955). Factor Endowment and Relative Commodity Prices.

Economica. 22(88), 336–341.

Samuelson, Paul A. (1948). International Trade and the Equalisation of Factor Prices,
Economic Journal, 163-184.

Abba P. Lerner(1952). Factor Prices and International Trade, Economica.

UNIT 3: FACTOR INTENSITY REVERSALS
CONTENTS
1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Single Factor and Multiple Factor Intensity Reversals
3.2 The Stopler-Samuelson Theorem
3.3 The Rybczynski Theorem
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References/Further Readings

1.0 Introduction

Factor intensity reversal is the relative importance of one factor versus others in
production in an industry, usually compared across industries. It is commonly defined by
ratios of factor quantities employed at common factor prices, but sometimes by factor
shares or by marginal rates of substitution between factors. This unit will also looked at
the effect of change in commodity prices on real factor rewards and the effect of factor
endowment changes on trade.

2.0Objective
At the end of this unit student should be able to
• Explain the meaning of factor intensity reversals
• Distinguish between the single factor and multiple factor intensity reversals
• Understand the effect of change in commodity prices on real factors rewards
(Stopler-Samuelson theorem
• Understand the effect of factor endowment changes on trade (Rybczynski
Theorem

3.0 Main Content

3.1Single Factor and Multiple Factor Intensity Reversals
Definitions of factor intensities are most simply provided in the case in which a pair of
countries produces two commodities with the help of two distinct productive factors. Let
labour and capital represent the two factors. Commodity A is deemed to be produced by
relatively labour-intensive techniques if the ratio of labour to capital employed in its
production exceeds the one utilized by commodity B. Assuming that technology exhibits
constant returns to scale, this ratio is a non-increasing function of the ratio of the wage
rate to capital rentals. For a country with given factor endowments, if the first commodity
is labour intensive at one set of outputs, it must remain so for all feasible (and efficient)
outputs in which factors are fully employed. However, even if the other country shares
the same technology, the first commodity need not to be labour intensive; the factor-
intensity ranking could be switched.

Factor intensity reversals may exist if one isoquant ‘sits on the other’ or if one isoquant
intersects the other at multiple points. The first is known as single factor intensity
reversal and the second as multiple factor intensity reversal.

Single Factor Intensity Reversal

The single factor intensity reversal is illustrated in Fig. 5.3.1 where the isoquant FF sits
on the isoquant CC at point R. It is only at R that a tangent representing the common
price line representing equal international price ratios can be drawn. The ray shows the
proportion in which the two factors are combined in different intensities for both
commodities at one factor price ratio. Lerner calls the ray OR a “radiant of tangency”
which is the sign of factor intensity reversal. Points of equilibrium to its left or right on
the two isoquants will reveal that the production functions have shifted in factor
intensity.Fromthe factor price equalisation theorem it was pointed out that food is
relatively land-intensive in Nigeria and clothing is relatively labour-intensive in Ghana.
Now Fig. 1 reveals that the factor proportions represented by the rays OE and OD to the
left of the ray OR show different factor intensities. The ray OE, as compared with ray
OD, shows that the production of land-intensive in Nigeria relative to the production of
food. The factor price ratio for both the commodities in Nigeria is the same as
represented by the parallel tangents, a = a1 at points E and D on the isoquants CC and FF
respectively

C
F
a1
a1

E
D
R
Land

S
F
K b1
b C

O Labour
 Figure 5.3.1 Single Factor Intensity Reversal

On the other side, rays OK and OS to the right of the ray OR show that clothing is labour
intensive relative to food production in Ghana, given parallel factor price lines b = b1.

The above analysis shows that clothing is relatively land-intensive in Nigeria and
relatively labour-intensive in Ghana. Nigeria will produce clothing instead of food by
substituting land for labour in producing cloth which is a labour intensive commodity
which means there has been factor intensity reversal. Factor prices for the production of
cloth in the two countries is also different as shown by the slopes of the price lines aandb.
It is not possible to tell from factor intensities which country will export which
commodity. Both countries will try to produce and export clothing and import food.

Multiple Factor Intensity Reversals

C
F
PN

E2 R
N
PG E1
Land

S
T
M
D1 F
D2 C

O L LG
Labour

Figure 5.3.2 Multiple Factor Intensity Reversal

Multiple factor intensity reversals occur when two isoquants intersect each other at
multiple points. From Fig. 5.3.2, where the two isoquants CC and FF intersect twice at M
and N. And in between these two points of intersection, the two isoquants are cut by a ray
OR from the origin at T and S. Points of equilibrium between the isoquants and the factor
price lines to the left or right of ray OR shows factor intensity reversals. The two rays
OE1 and OE2 on the factor price line PNLN represent land/labour ratios in the production
of food and clothing in Nigeria. Rays OD1 and OD2, show similar ratios on the factor
price line PGLGin Ghana. This shows that clothing is land-intensive in Nigeria i.e. point
E2 but labour-intensive in Ghana i.e. point D2, whereas food is labour-intensive in Nigeria
(point E1) but land-intensive in Ghana (point D1). Therefore, the land-intensive
commodity food is labour-intensive in the land-abundant country Nigeria, while it is
land-intensive in the labour-abundant country Ghana. This shows factor intensity
reversals. But factor prices differ in the two countries as points E1and D1 of the isoquant
FF lie on two different factor price lines PNLN and PGLG. Since both countries will export
food and import clothing by substituting their factors this will affect the factor-price
equalisation theorem to breaks down.

Self Assessment exercise:

Distinguish between the single factor intensity reversals and multiple factor intensity
reversals.

3.2 The Stopler-Samuelson Theorem

The Stolper–Samuelson theorem is a basic theorem in Heckscher–Ohlintrade theory. It

describes the relationship between relative prices of output and relative factor rewards
specifically, realwages and realreturns to capital.Stopler-Samuelson theorem examines
the implications of a change in commodity prices for the real rewards of factors. The
factor-price equalisation theory relates movements in commodity prices to the ratio of
factor rewards. However, the Stopler-Samuelson theorem relates movements in
commodity prices to individual rewards. It states that in a two-factor two-commodity
economy a rise in the price of a commodity increases the real reward of the abundant
factor used in the production of the commodity of which the price has risen, and
decreases the real reward of the scarce factor, and vice-versa.

The Stopler-Samuelson theorem is based on the following assumptions:

1. There are two countries which trade with each other but the analysis is
geometrically confined to one country.
2. These countries produce only two commodities.
3. No commodity is an input into the production of another.
4. These two commodities are produced with only two factor inputs, labour and
capital.
5. Production functions of both commodities are linear and homogenous of degree
one.
6. Both factors are fixed in supply and fully employed.
7. Both factors are mobile between sectors but not between countries.
9. There is perfect competition in the factor and product markets.
10. The production of one of the commodity is capital-intensive and the other
commodity is labour-intensive.
11. Labour is an abundant factor of production and capital is a scarce factor.

Given the assumptions above and moving from no trade to free trade will definitely raises
the returns to the factors used intensively in the rising-price industry and lower the
returns to the factors used intensively in the falling price industry. But the falling price
industry will release more capital and less labour compared to the demand of the rising
price industry. This will lead to the substitution towards the use of more capital and less
labour in both industries. With increase in the use of more capital relative to labour, the
marginal productivity of capital will fall and that of labour will rise for both
commodities. With the reward of each factor equal to its marginal value productivity, the
real return to capital will fall and the real wage of labour will rise. Therefore, the
marginal productivity of capital will be lower after trade than before trade. This proves
the Stopler-Samuelson Theorem that international trade raises the price of the export
commodity and increases the real reward of the abundant factor used in the production of
the commodity of which the price has risen, and decreases the real reward of the scarce
factor, and vice-versa.

There are some implications of the theorem on some economyand firstly, it leads to the
conclusion that opening of trade leads to expansion in the production of commodity
produced with the abundant factor whose real reward increases. Thus income distribution
moves in favour of the abundant factor and against the scarce factor. On the contrary, the
imposition of a tariff on the importable commodity in such a country will reduce the level
of trade and benefit the scarce factor. In other words, the income distribution is against
the abundant factor and in favour of the scarce factor.

Secondly, the Stopler-Samuelson theorem has important implications for developing

countries. For example for labour-abundant developing countries, the policy of export
promotion rather than import substitution through tariffs should be adopted because
export promotion will increase the level of trade, raise the real reward of the abundant
factor labour and lead to increased income and faster growth. On the other hand, the
policy of import substitution through protective tariffs will lower the real reward of the
abundant factor labour and raise that of the scarce factor capital thereby slowing down
income and growth.

Self Assessment exercise:

Discuss the Stopler-Samuelson theorem.

3.3 The Rybczynski Theorem

The Rybczynski theorem was developed in 1955. It states that at constant relative goods
prices, a rise in the endowment of one factor will lead to a more than proportional
expansion of the output in the sector which uses that factor intensively, and an absolute
decline of the output of the other good.In the context of the Heckscher-Ohlin model of
international trade, open trade between two regions often leads to changes in relative
factor supplies between the regions. This can lead to an adjustment in the quantities and
types of outputs between the two regions. The Rybczynski theorem explains the outcome
from an increase in one of this factor's supply as well as the effect on the output of a good
which depends on an opposing factor.Eventually, across both countries, market forces
would return the system toward equality of production in regard to input prices such as
wages (the state of factor price equalization).

The Rybczynski theorem states that in a two-factor two-commodity economy a rise in the
supply of one factor, keeping the supply of the other factor constant, leads to an increase
in the output of the commodity that uses the increased factor intensively, and to a decline
in the output of the other commodity. For example, if the supply of labour increases, the
output of the labour-intensive commodity increases and the output of the capital-intensive
commodity declines. On the contrary, if the supply of capital increases, the output of
capital-intensive commodity increases and the output of the labour-intensive commodity
decline. And this theorem is based on the following assumptions:

1. There are two countries which trade with each other. But the analysis is
geometrically confined to one country.
2. This country produces only two commodities X and Y.
3. These commodities are produced with two factors, labour and capital.
4. These two factors are perfectly divisible, perfectly mobile and are substitutable in
some degree.
5. The production functions of both commodities are different. Commodities are
linear and homogeneous.
6. The factor intensity of each commodity is different. Commodity X is labour-
intensive and commodity Y is capital-intensive.
7. The commodity and factor prices are constant.
8. There is perfect competition in commodity and factor markets.
9. Only the supply of one factor is changed while keeping that of the other constant.

Rvbczynski concludes that in an open economy if it is assumed that the commodity using
much of the factor of which the quantity has increased, is an item of export, then the
external terms of trade will deteriorate, on the other hand, should the commodity be an
import, the terms of trade will improve. If the country happens to be a small and is not in
a position to influence world price ratios by its internal adjustments, then,
unambiguously, the output of commodity X will increase and that of commodity Y will
decline.

Self Assessment exercise:

Briefly explain the Rybczynski theorem.

4.0 Conclusion

This unit concludes that the Stolper-Samuelson theorem demonstrates how changes in
output prices affect the prices of the factors when positive production and zero economic
profit are maintained in each industry. It is useful in analyzing the effects on factor
income, either when countries move from autarky to free trade or when tariffs or other
government regulations are imposed within the context of H-O model. The Rybczynski
theorem displays how change in an endowment affects the outputs of the goods when full
employment is sustained. The theorem is useful in analyzing the effects of
capitalinvestment, immigration and emigration within the context of a Heckscher-Ohlin
model.

5.0 Summary

In summary this unit discussed intensively the single factor and multiple factor intensity
reversals. The effect of change in commodity prices on real factor rewards and the effect
of factor endowment changes on trade.

6.0 Tutor-Marked Assignment

a. Explain theterm factor intensity reversals
b. Differentiate between the single factor intensity reversal and multiple factor
intensity reversal.
c. Discuss the effects of change in commodity prices on real factor rewards in
international trade.
d. Discuss the effect of factor endowment changes on international trade.
7.0 References/Further Readings
Jhingan M.L, (2010); International Economics, 6th edition, Vrinda Publications (P)
Ltd. Delhi, India

Jhingan M.L, (2010); Macroeconomics Theory, 12th edition, Vrinda Publications (P)
Ltd. Delhi, India

Krugman Obstfeld, (1975); International Economics Theory and Policy, 8th edition
Pearson International edition,.
Olasupo Akano (1995); International trade theory and evidence, Rebonik publication Ltd,
lagos.

Krugman Paul, Obstfeld Maurice (2007). Resources and Trade: The Heckscher-Ohlin
Model. International Economics: Theory and Policy. Boston, Addison Wesley. pp. 67–
92.

RybczynskiTadeusz (1955). Factor Endowment and Relative Commodity Prices.

Economica. 22(88), 336–341.

Samuelson, Paul A. (1948). International Trade and the Equalisation of Factor Prices,
Economic Journal, 163-184.

Abba P. Lerner(1952). Factor Prices and International Trade, Economica.