I.

INTRODUCTION

1.1. Meaning, Nature, and Scope of International Economics

Today, no country inhabits an economic island. Its firms, industries, its commercial activities in
goods and services, its technology and available capital, its standard of living, and all other
features of its economy are related to the economies of other countries. The process of
globalization has left hardly any country isolated or unaffected by worldwide economic
conditions outside its own borders. Events outside the borders of a country can have a significant
impact on its economic performance and policy choices.

The resulting interdependence is very important for the economic well-being of most nations of
the world. While some protest the destruction of traditional ways of life and the challenge to
national sovereignty caused by greater trade and investment, others note that trade and
investment have been engines of growth that allow rising standards of living. Every country
benefits tremendously from its interactions with other countries, and every country can enhance
these benefits and lessen the costs of interdependence through national policies that affect trade,
investment, the value of its currency, and the level of national output.

International economics deals with theory and practice of international trade and finance. It deals
with the economic relations among nations. In other words, it comprises of:
1. International trade theory – examines the basis for (or the forces that give rise to)
international trade and the benefits from such a trade.
2. International trade policy – studies the reasons for and the results of obstructions to the
free flow of trade.
3. The balance of payments – examines a nation’s total payments to and total receipts from
the rest of the world. These involve the exchange of one currency for the others.
4. Adjustment in the balance of payments – deals with the mechanism of adjustment to
balance of payments disequilibria under different international monetary systems.

Number (1) and (2) belong to the subject matter international trade while (3) and (4) are the
concerns of international finance (open-economy macroeconomics).
1.2. The Components of International Economics

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International economics into two major branches:

 International monetary economics, and

 International trade theory (or the pure theory of trade).

1. International Monetary Economics

International monetary economics is oriented towards the monetary aspects of international

monetary relations.

Its approach is mainly macroeconomic in nature, and it particularly deals with the short-run
problems of balanced-of-payments disequilibrium and adjustment.

2. International Trade Theory

The international trade (or pure theory of trade), in contrast to international monetary economics,
is a long-run, static-equilibrium theory of barter. Here the short-run monetary adjustment process
is assumed completed, with money having no influence whatsoever on the nature or position of
long-run equilibrium.

1.3. The Importance of International Economics

If so, why study international economics separately from (say) money and banking or labour
economics? Each of the latter branches has specific groups of transactors. So has international
economics - residents of different nations. Traditionally, two reasons are given to justify a
separate study of international economics. 1. In the long run, factors of production such as labour
and capital move freely within the national frontiers, while their mobility is severely restricted
between nations. As a result, it is argued, factors cannot move to any location to take advantage
of higher rewards (reflecting higher productivities). But we know that factors are not completely
immobile between countries. The great international migrations of the nineteenth century are
instant reminders to the contrary. 2. The second point about the need for special treatment of
international economics is that international trade takes place between sovereign nations, and
therefore, it is possible and indeed likely, that in pursuance of conflicting national objectives they
will adopt policies which will, intentionally or not, tend to diminish trade flows. International
economics consists of two main branches- international trade and international finance. The
former corresponds to its microeconomic counterpart and employs the methods of static

2
equilibrium theory to barter exchange with money assumed to be a veil. The theory of
international finance, on the other hand, is fundamentally macroeconomic in nature and deals
with international monetary relations which assumes special significance in the event of balance
of payment disequilibrium and the adjustment that it calls for. In the present day world,
economic interdependence among nations is very strong, particularly in matters of
macroeconomic policy.

1.4. International Economics and Economic Theories

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

Although most of international economics represents the application of general microeconomic

and macroeconomic principles to the international context, many theoretical advances were made
in the field of international economics itself, and only subsequently did they find their way into
the body of general economic theory. Production and general equilibrium theory, growth theory,
welfare economics, as well as many other economic theories, have also benefited from work in
the international sphere. These contributions attest to the vitality and importance of international
economics as a special branch of economics.

1.5. Purposes of Economic Theories and/or Models

The model illustrates the essence of the real object it is designed to resemble. Economists also
use models to understand the world, but an economist’s model is more likely to be made of
symbols and equations. Economists build their “toy economies” to help explain economic

3
 variables, such as GDP, inflation, and unemployment. Economic models illustrate, often in
mathematical terms, the relationships among the variables. They are useful because they help us
to dispense with irrelevant details and to focus on important connections. Models have two kinds
of variables: endogenous variables and exogenous variables. Endogenous variables are those
variables that a model tries to explain. Exogenous variables are those variables that a model takes
as given.

The purpose of a model is to show how the exogenous variables affect the endogenous variables.
Exogenous variables come from outside the model and serve as the model’s input, whereas
endogenous variables are determined inside the model and are the model’s output. To make these
ideas more concrete, let’s review the most celebrated of all economic models—the model of
supply and demand. Imagine that an economist were interested in figuring out what factors
influence the price of pizza and the quantity of pizza sold. He or she would develop a model that
described the behavior of pizza buyers, the behavior of pizza sellers, and their interaction in the
market for pizza. For example, the economist supposes that the quantity of pizza demanded by
consumers Qd depends on the price of pizza P and on aggregate income Y. This relationship is
expressed in the equation

Qd= D(P,Y)

Where (D), represents the demand function

To develop a model, economists generally follow these steps:

 Decide on the assumptions to be used in developing the model

 Formulate a testable hypothesis.
 Use economic data to test the hypothesis.
 Revise the model if it fails to explain well the economic data.
 Retain the revised model to help answer similar economic questions in the future.

1.6. Testing a Hypothesis/Theory/ Model

Once an econometric model has been specified, various hypotheses can be stated in terms of the
unknown parameters. An empirical analysis, by definition, requires data. After data on the

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 relevant variables have been collected, econometric methods are used to estimate the parameters
in the econometric model and to formally test hypotheses of interest. In some cases, the
econometric model is used to make predictions in either the testing of a theory or the study of a
policy’s impact.

1.7. The Role of Assumptions

Any model is based on making assumptions because models have to be simplified to be useful.
We cannot analyze an economic issue unless we reduce its complexity.

For example, economic models make behavioral assumptions about the motives of consumers
and firms. Economists assume that consumers will buy those goods and services that will
maximize their wellbeing or their satisfaction. Similarly, economists assume that firms act to
maximize their profits. These assumptions are simplifications because they do not describe the
motives of every consumer and every firm.
How can we know if the assumptions in a model are too simplified or too limiting?

We discover this when we form hypotheses based on these assumptions and test these
hypotheses using real-world information.

1.8. Summary and Conclusions

 International economics deals with theory and practice of international trade and finance.
It deals with the economic relations among nations.
 International economics into two major branches: International monetary economics and
International trade theory (or the pure theory of trade).
 Although most of international economics represents the application of general
microeconomic and macroeconomic principles to the international context, many
theoretical advances were made in the field of international economics itself, and only
subsequently did they find their way into the body of general economic theory.
 The model illustrates the essence of the real object it is designed to resemble. Economists
also use models to understand the world, but an economist’s model is more likely to be
made of symbols and equations.

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 II INTERNATIONAL TRADE THEORIES

2.1. Historical Development of Modern Trade Theory

The basic questions that we seek to answer in this chapter are: (1) What is the basis for trade and
what are the gains from trade? Presumably (and as in the case of an individual), a nation will
voluntarily engage in trade only if it benefits from trade. However, how are gains from trade
generated? How large are the gains and how are they divided among the trading nations? (2)
What is the pattern of trade? That is, what commodities are traded and which commodities are
exported and imported by each nation?
2.1.1. The Mercantilists’ View on Trade

During the period 1500-1800, a group of writers appeared in Europe who was concerned with the
process of nation building. According to the mercantilists, the central question was how a nation
could regulate its domestic and international affairs so as to promote its own interests. If a
country could achieve a favorable trade balance (a surplus of exports over imports), it would
realize net payments received from the rest of the world in the form of gold and silver. To
promote a favorable trade balance, the mercantilists advocated government regulation of trade.
Tariffs, quotas, and other trade policies were proposed by the mercantilists to minimize imports
in order to protect a nation's trade position. Briefly, the mercantilists maintained that the way for
a nation to become rich and powerful was to export more than it imported. Thus, the government
had to do all in its power to stimulate the nation's exports and discourage and restrict imports
(particularly the import of luxury consumption goods).

The mercantilists measured the wealth of a nation by the stock of precious metals it possessed.
The mercantile system is based on the idea that exports should be encouraged, and imports
discouraged. The difference would be settled by an inflow of .precious metals-mostly gold. To
sum up, mercantilism holds that the prosperity of a nation is dependent on its supply of capital.
Capital can be increased mainly through a positive balance of trade with other nations. Hence,
national wealth and power are best served by encouraging exports and collecting precious metals
in return. To govern the national economy properly, the government should advance these goals
by adopting protectionist policy.

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2.1.2. Physiocracy: A Link between Mercantilism and Classical School

The physiocrats’
contributions to
microeconomic theory
were
not as significant as
their contributions to
macroeconomic
theory. They believed
that the basic
motivation for the
economic
7
activities of human
beings was the desire to
maximize gain.
Although the
physiocrats did not
develop a coherent
theory of
prices, they concluded
that free competition
led to the best price

8
and that society would
benefit if individuals
followed their self-
interest. Furthermore,
believing that the only
source of a net
product was agriculture,
they concluded that the
burden of taxes
would ultimately rest on
land.
9
The physiocrats’
contributions to
microeconomic theory
were
not as significant as
their contributions to
macroeconomic
theory. They believed
that the basic
motivation for the
economic
10
activities of human
beings was the desire to
maximize gain.
Although the
physiocrats did not
develop a coherent
theory of
prices, they concluded
that free competition
led to the best price

11
and that society would
benefit if individuals
followed their self-
interest. Furthermore,
believing that the only
source of a net
product was agriculture,
they concluded that the
burden of taxes
would ultimately rest on
land.
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Physiocracy was an early school
of economic doctrine prevailed
in France
in the middle of the 18th
century. Physiocrats are
considered as the first school
of economic thought and is
considered as the founders of
economic science. They
were supposed to be the first to
understand the general
principles in economics.
Based on that, they developed a
theoretical system in
economics.
13
The physiocrats’ contributions to microeconomic theory were not as significant as their
contributions to macroeconomic theory. They believed that the basic motivation for the
economic activities of human beings was the desire to maximize gain. Although the physiocrats’
did not develop a coherent theory of prices, they concluded that free competition led to the best
price and that society would benefit if individuals followed their self-interest. Furthermore,
believing that the only source of a net product was agriculture, they concluded that the burden of
taxes would ultimately rest on land.

They recognized that an individual who appears to be working independently in a market

economy is actually working for others and that these independent activities are integrated by the
price system. They recognized that an individual who appears to be working independently in a
market economy is actually working for others and that these independent activities are
integrated by the price system.

The physiocrats maintained that the primary obstacles to economic growth proceeded from the
mercantilist policies regulating domestic and foreign trade. They objected particularly to the tax
system of the mercantilists and advocated that a single tax be levied on land. Of course,
according to their theory, all taxes would ultimately fall on land anyway, but only after causing
much friction in the economic system. The small-scale agriculture of the feudal economy was
replaced by large-scale agriculture. Thus, the wealth and power of the French economy would be
increased.

The physiocrats, who

considered the source of
the net product to
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be agriculture,
maintained that laissez
faire would lead to
increased agricultural
production and
ultimately to greater
economic growth.
2.1.3. The Classical /Traditional Trade Theories

By the late eighteenth century, classical economists such as David Hume and Adam Smith began
to criticize mercantilism. David Hume attacked the mercantilist idea that a nation could continue
to accumulate specie without any repercussions to its international competitive position.

1. Adam Smith’s theory of absolute advantage

Adam smith (1723-1790) provided the basic building blocks for the construction of the classical
theory of international trade.

He enunciated the theory in terms of what is called Absolute Advantage model. Adam Smith
viewed that for two nations to trade with each other voluntarily, both nations must gain.
According to Adam Smith, trade between two nations is based on absolute advantage. When one
nation is more efficient than in the production of one commodity but is less efficient than the
15
other nation in producing a second commodity, then both nations through trade can gain by each
specializing in the production of the commodity of its absolute advantage and exchanging part of
its output with the other nation for the commodity of its absolute disadvantage.

He reasoned that as the nation experienced trade surplus and accumulated more gold, money
supply should be increased. Hume hence argued that it is impossible to continue to maintain a
positive balance of trade in the long run. Adam Smith refuted the idea that the wealth of a nation
is measured by the amount of treasury. He held that a nation’s wealth was reflected in its
productive capacity, not in its holdings of precious metals. He criticized the doctrine by
demonstrating that free trade benefits both parties. He also argued that division of labor and
specialization in production results in economies of scale, which improves efficiency and growth

Assumptions of the theory of absolute advantage

a) Labor is the only factor of production and is homogenous.

b) Labor was completely free to move within a single country, yet it was entirely immobile
internationally.

c) Both countries can produce both commodities.

d) No transportation costs were involved in trade.

e) There existed no other barriers, such as tariffs and quotas, to trade between countries
(promotion of free trade).

f) Constant returns to scale.

Illustration of absolute advantage

Imagine a hypothetical world composed of only two countries, country A and country B.

Both countries produce significant quantities of wheat and oil for domestic consumption, and
there is absolutely no trade relations, i.e., each are taken to be operating in a state of isolation
(autarky). Assume for the moment also that the entire value of the two commodities is the
amount of labor used in their production. Now suppose, further, that one man-hour of labor can
produce the following quantities of wheat and oil in the two respective countries:

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Table 2.1: Absolute advantage

Table 2.1 and Figure 2.1 reveals that country A could produce 10 barrel of oil and 5 quintal of
wheat and B could produce 5 barrel of oil and 10 quintal of wheat between these two extremes
with one man hour of labor.

The different combinations that country A could produce are represented by the line GG’ in the
Figure 2.1 below. This is referred to as country A’s production possibility frontier.

Fig 2.1: Production possibility Frointer

Apparently, country A has an absolute advantage in the production of oil (10 barrel is greater
than 5 barrel), and country B has an absolute advantage in the production of wheat (10 quintal is
greater than 5 quintal).

To see the benefit from an international trade, it is better to begin from autarky. Country A
would export oil to country B, in return for which country B would export wheat to country A. In

17
this case there is a scope for complete specialization in production in both countries. The effect
of opening trade between the two countries is shown in the following table.

The combined gain to both countries from trade will be 5 units of oil and 5 unit of wheat for
country A and B, respectively.

Table 2.2: production after specialization and gain from trade

Criticism on theory of absolute advantage

Smith has been criticized for his vagueness and lack of clarity. Accordingly, Smith assumes
without argument that international trade requires an exporting country to have superiority with a
given amount of capital and labor to produce a larger output than any 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.

2. Theory of Comparative Advantage

Like Adam Smith, David Ricardo emphasized the supply side of the market.

The immediate basis for trade stemmed from cost differences between nations, which were
underlined by their natural and acquired advantages. Unlike Adam Smith, who emphasized the
importance of absolute cost differences among nations, David Ricardo emphasized comparative
cost differences. Comparative Advantage is a situation in which one country specialize in
producing the goods it produces most efficiently and buys the products it produces less
efficiently from other countries, even if it could produce the goods more efficiently itself.

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Assumptions of the theory of comparative advantage

1) The world consists of two nations, each using a single input to produce two commodities.
2) In each nation, labor is the only input.
3) Labor is completely free to move within a single country among industries, yet is entirely
immobile internationally.
4) Nations may use different technologies, but all firms within each nation utilize a common
technology for each commodity.
5) There are similar test between countries.
6) Perfect competition prevails in all markets.
7) Free trade occurs between nations.
8) Transaction costs are zero.
9) Firms make an attempt to maximize profits, where as consumers maximize satisfaction
through their consumption decisions.
10) Trade is balanced.

Illustration of comparative advantage

In general, according to Ricardo’s comparative advantage principle, even if a nation has an absolute

cost disadvantage in the production of both goods; a basis for mutually beneficial trade may still

exist. The less efficient nation should specialize in and export that good in which it is relatively less

inefficient (where its absolute disadvantage is the least) and the more efficient nation should

specialize in and export that good in which it is relatively more efficient (where its absolute

advantage is the greatest).

To demonstrate the principle of comparative advantage, Ricardo used the following simplifying

assumption;

1. The world consists of two nations (home &foreign), each using a single input (labor) to produce

two commodities (wine &cheese). I.e. two – nations, two-commodities, and a single input.

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 2. In each nation, labor is the only input (the labor theory of value).Each nation has a fixed

endowment of labor, and labor is fully employed and homogeneous.

3. Labor can move freely among industries with in a nation but is incapable of moving between

nations.

4. The level of technology is fixed for both nations. Different nations may use different

technologies, but all firms within each nation utilize a common production method for each

commodity.

5. Unit costs do not vary with the level of production (constant returns to scale) and are

proportional to the amount of labor used.

6. Perfect competition prevails in all markets. That is,

- No single buyer or seller is large enough to influence the market price- all are price takers.

- There is free entry in to and exit from the industry, and

- The price of each product equals its marginal cost of production.

7. Free trade occurs between counties; that is, no government barriers to trade exist.

8. Transport costs are zero. Consumers will thus be indifferent between domestically produced and

imported versions of a product if the domestic prices of the two products are equal.

9. Firms seek to maximize their profit, whereas consumers seek to maximize their satisfaction.

10. There is no money illusion

11. Trade is balanced (exports must pay for imports), thus ruling out flows of money between

nations.

Dear learners! Let’s see Ricardo’s comparative advantage if one nation (home) has absolute cost

advantage in the production of both goods (cheese & wine).

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Assume that in one hour’s time, home workers can produce 40 gallons of wine or 40 pounds of cheese,

while foreign Workers can produce 20 gallons of wine or 10 pounds of cheese.

The following table summarizes the illustration.

Out put per labor hour

Nation Wine Cheese

U.S (home) 40 gallons 40 pounds

U.K (foreign) 20 gallons 10 pounds

According to A. smith’s principle of absolute advantage, there is no basis for mutually beneficial

specialization and trade, because home is more efficient in the production of both goods.

Ricardo’s principle of comparative advantage, however, recognizes that the home is four times as

40 40
efficient in cheese production ( 10 = 4) but only twice as efficient in wine production ( 20 = 2). The home

thus has a greater absolute advantage in cheese than in wine, while the foreign has a smaller absolute

disadvantage in wine than in cheese. Hence, home has a comparative advantage in cheese production

and specializes in it, and foreign has a comparative advantage in wine production and specializes in it.

Each nation exports that good in which it has a comparative advantage and the output gains from

specialization will be distributed to the two nations through the process of trade.

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Example 2:In his example Ricardo imagined two countries, England and Portugal, producing two
goods, cloth and wine, using labor as the sole input in production.

Instead of assuming, as Adam Smith did, that England is more productive in producing one good
and Portugal is more productive in the other; Ricardo assumed that Portugal was more
productive in both goods. Based on Smith's intuition, then, it would seem that trade could not be
advantageous, at least for England. Ricardo showed that the specialization good in each country
should be that good in which the country had a comparative advantage in production.

In order to identify a country's comparative advantage, it requires a comparison of production

costs across countries. This is illustrated in terms of Ricardo’s well known example of trade
between England and Portugal as shown in Table 2.3

Table 2.3: Ricardo’s comparative cost

The table shows that the production of a unit of wine in England requires 120 men for a year
while a unit of cloth requires 100 men for the same period. On the other hand, the production of
the same quantities of wine and cloth in Portugal requires 80 and 90 men respectively. Thus,
England uses more labor than Portugal in producing both wine and cloth.

In other words, the Portuguese labor is more efficient than the English labor in producing both
the products. So Portugal possesses an absolute advantage in both wine and cloth.However,
Portugal would benefit more by producing wine and exporting it to England because it possesses
greater comparative advantage in it.

This is because the cost of production of wine (80/120 men) is less than the cost of production of
cloth (90/100 men).

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Fig 2.2 Theory of Comparative Advantage

On the other hand, it is in England’s interest to specialize in the production of cloth in which it
has the least comparative disadvantage. This is because the cost of cloth production in England
in less (100/90 men) as compared with wine (120/80 men). PL is the production possibility curve
of Portugal, and EG that of England. Portugal produces OL of wine and OP of cloth, as against
OG of wine and OE of cloth produced by England.

But the slope of ER (parallel to PL) reveals that Portugal has a greater comparative advantage in
the production of wine because if it gives up the resources required to produce OE of cloth, it can
produce OR of wine which is greater than OG of wine of England.

On the other hand, England had the least comparative disadvantage in the production of OE of
cloth. Thus, Portugal will export OR of wine to England in exchange for OE of cloth from her.
Gains from Trade and Their Distribution

The opportunity for gain can be seen immediately by comparing the real exchange ratios that
will prevail in each country in the absence of international trade.

In Portugal, in isolation 1 unit of cloth will exchange for 1.13 barrels of wine Table 2.4:
Exchange rate before trade

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Suppose now, as Ricardo did, that both countries are offered the chance to trade at the barter
exchange ratio 1 cloth for 1 wine.

Portugal will find such trade an attractive way to acquire cloth.Instead of giving up 1.13 barrels
of wine to obtain 1 cloth, it need give up only 1 barrel of wine. It saves 0.13 barrel of wine on
each unit of cloth acquired. Consequently, Portugal will specialize in wine production, and
obtain its cloth from England through trade.

Similarly, England will benefit because for one cloth it can obtain a barrel of wine, instead of
only 0.83 of a barrel as in direct production. It will specialize in cloth, obtaining wine from
Portugal through trade at less cost than it can be produced at home.Thus Ricardo showed that
both countries gain, even though Portugal enjoys an absolute advantage in both commodities.

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The gains from trade and their distribution are also shown in Figure 2.3 where the line C1W2
depicts the domestic exchange ratio 1 unit of cloth = 0.83 unit of wine of England, and the line
WI C2 that of Portugal at the domestic exchange ratio 1 unit of wine = 0.89 unit of cloth.

The line C1 W1 shows the exchange rate of trade of 1 unit of cloth = 1 unit of wine between the
two countries.

At this exchange rate, England gains W2W1 (0.17 unit) of wine, while Portugal gains C2C1
(0.11 unit) of cloth. At this point, you may ask, “How did Ricardo know that the barter terms of
trade between Portugal and England would be 1C: 1W?”The answer is that he did not know
precisely what that rate would be.

All he knew was that the international exchange ratio had to lie somewhere in between the two
domestic ratios, that is,

Portugal 1C : 1.13W

England 1C : 0.83W

Any ratio between these two limits will permit both countries to gain from trade.He simply said
that the two countries would gain from trade so long as England concentrated on the production
of cloth and Portugal on the production of wine. Ricardo did not give a name to the principle, but
it has long been known as the law of comparative costs.

Criticisms on the comparative cost advantage theory

The most severe criticism of the comparative advantage doctrine is that it is based on the labor
theory of value

- Labor is also not used in the same fixed proportion in the production of all commodities.
- Ricardo ignores transport costs in determining comparative advantage in trade.
- The assumption that factors of production of mobility
- The theory neglects the role of technological innovations neglects the demand side.
- It fails to show how the gains, from trade are distributed between countries.

Extension of the Classical Theory

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 1. The Offer Curves of a Nation

Offer curves incorporate elements of both demand and supply. Alternatively, we can say that the
offer curve of a nation shows the willingness of the nation to import and export at various
re1ative commodity prices. The offer curve of a nation can be derived rather easily and
somewhat informally from the nation's production frontier, its indifference map, and the various
hypothetical relative commodity prices at which trade could take place.

Derivation of Offer Curve

The terms of trade or offer curve of the countries, are determined by the intensity of domestic
demand for foreign goods and of the foreign demand for domestic goods. Figure 2.13 (a) shows a
production possibility curve and a set of community indifference curves that characterize
demand in country I. In the absence of trade, equilibrium will be established at point A, where an
indifference curve is tangential to the production possibility curve. At this point, the MRTS in
production equals the MRS in consumption.

The highest level of satisfaction that the country can enjoy under autarky is that symbolized by
the indifference curve I. The price ratio that will be ruling under autarky is given by the line
P=¼, which is tangential to the production-possibility curve and the indifference curve at A.

Suppose now that we open up the, possibility of international trade. Let country I has a
comparative advantage in production of commodity X and that the new terms of trade
established under trade are as shown by the line P = ½ in Figure 2.13 (a). country I will then
produce at point F and consume at point H, and export FG (40X) of commodity X in exchange
for GH (20Y) imports of commodity Y. By trade, country I can move to the indifference curve
II, which represents a higher level of satisfaction than do I. Had the terms of trade been even
more favorable, for instance such as represented by P=1, the country could have reached
indifference curve III by trading BC (60X) of X for CE (60Y) of Y.

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Figure 2.13 Offer curve for country I

We can now show how country I's volume of exports and imports change as the terms of trade
change. As it has been shown in Figure 2.13 (b), on the vertical axis, we have net Imports of Y
and on the horizontal axis we have net Exports of X. The triangle 0GH in Figure (b) corresponds
to the trade triangle HGF in Figure 2.13 (b). It shows International Trade and Finance that if the
terms of trade are 0H (these terms of trade are the same as those depicted by PF = ½ in Figure
2.13 (a)),"40X will be exchanged for 20Y.

If the terms of trade instead should change to 0E (which corresponds to PB = 1 in Figure 2.13
(a)), 60X would be exchanged for 60Y (the triangle 0CE corresponds to the trade triangle BCE
in Figure 2.13 (a).

In this way we can trace out a pattern of points that show how the traded volumes change when
the terms of trade change. If we join together all these points for country I, we get a curve such
as 0K in Figure 2.13(b).0K is an example of an offer curve.

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Thus an offer curve shows how the volumes traded change when the terms of trade change. The
offer curve of the trade partner is derived in a completely analogous way, that is, from its
production frontier, its indifference map, and the various relative commodity prices at which
trade could take place.

Figure 2.13 Offer curve for country II

Figure 2.13 (a) indicates that, country II starts at the autarky equilibrium point A’. when trade
takes place at PF= 2 , country II moves to point F' in production, exchanges 40Y for 20X with
country I, and reaches point H' on its indifference curve II'.

At PE’’ = 1 in Figure 2.13 (a), country II would move instead to point F' in production, exchange
60Y for 60X with country I, and reach point E' on its indifference curve III. Joining the origin
with points H' and E' and other points similarly obtained, we generate country II’s offer curve in
the right panel.

The offer curve of country II’s also shows how much imports of commodity X country II
demands to be willing to export various quantities of commodity Y.

28
The Equilibrium Relative Commodity Price with Trade

The offer curves of the two trading countries intersect at point E. This is the only equilibrium
point and the equilibrium terms of trade are given by the ray 0E from the origin. Only at this
equilibrium price will trade be balanced between the two nations. At any other relative
commodity price, the desired quantities of imports and exports of the two commodities would
not be equal. This would put pressure on the relative commodity price to move toward its
equilibrium level.

The offer curves of country I and II in Figure 2.14 intersect at point E, defining equilibrium
relative price (PB =PB’,= 1). At PB, country I offers 60X for 60Y and country II offers exactly
60Y for 60X. Thus trade is in equilibrium at PB.

Figure 2.14 Equilibrium Relative Commodity Price with Trade

At any other price, trade would not be in equilibrium. This will continue until supply and
demand become equal at PB. The shape of the offer curves are determined by both supply and
demand conditions in the respective countries. The limits within which they will fall are given by

29
the autarky terms of trade in the two countries. With improving terms of trade, a country is
willing to offer more and more of its exports for more imports.

After a certain amount of trade, however, the country could become more and more unwilling to
accept an increase in the amount of imports, even though they are offered at improving terms of
trade.The offer curve is a general-equilibrium concept. It is determined jointly by production and
consumption conditions.

Change In Terms Of Trade

The terms of trade of a nation are defined as the ratio of the price of its export commodity to the
price of its import commodity.

Since in a two nation world, the exports of a nation are the imports of its trade partner, the terms
of trade of the 'latter are equal to the inverse, or reciprocal, of the terms of trade of the former.
These terms of trade are often referred to as the commodity or net barter terms of trade. As
supply and demand considerations change over time as a result of factors affecting demand and
supply of tradable, offer curves will shift, changing the volume and the terms of trade.

An improvement in a nation's terms of trade is usually regarded as beneficial to the nation in the
sense that the prices that the nation receives for its exports rise relative to the prices that it pays
for imports. For instance, if a nation's tastes change and desire for its import commodity
increases, the nation's offer curve will rotate closer to the axis measuring the commodity of its
comparative advantage. The reason for this is that the nation is now willing to give up more of its
export commodity in exchange for any given amount of the imported commodity because of its
increased desire for the imported commodity. This results in an expanded volume of trade but in
decline in the nation's terms of trade.

2.1.4. The Neoclassical Trade Theories

The H-O Theorem [Factor-Endowment Theory]

Assumptions of the H-O Model

30
 1. There are only two countries (say, Ethiopia and South Africa) which produce two
commodities (Wheat, W and cloth, C) using only two factors of production (capital,
K and labor, L).
2. There are no transport costs or other barriers to trade.
3. There is perfect competition in both commodity and factor markets.
4. All production functions exhibit constant returns to scale.
5. The production functions are such that the two commodities show different factor
intensities at any common factor price ratio. For our discussion, we assume W to be
labor intensive and C to be capital intensive.
6. The production functions differ between commodities, but are the same in both
countries – both nations have access to and use the same general production
techniques.
7. Tastes are identical in the two countries – there are similar demand conditions in
the two nations.
8. Labor and capital are perfectly mobile between industries within the same country,
but are perfectly immobile between countries.
9. All resources are fully employed;
10. The specialization which results from free trade is incomplete in both nations;
11. There are no factor-intensity reversals

Given these basic assumptions, a nation will export that commodity for which a large amount of
the relatively abundant (cheap) input is used. It will import that commodity in the production of
which the relatively scarce (expensive) input is used. H-O theory of trade patterns says that
countries will have a comparative advantage in (and thus will export) products whose production
uses their abundant factors intensively and comparative disadvantage in (and thus will import)
products whose production uses their scarce factors intensively. This is known as the factor –
proportions (or the H-O) theorem.

The H-O theory, therefore, predicts that countries export the products that use their abundant
factors intensively and import those products that use their scarce factors intensively. Out of
many forces working together, the H-O model isolates the difference in the physical availability

31
or supply of factors of production among nations to explain the difference in relative commodity
prices. The difference in relative commodity prices is the cause for trade among nations.

There are two definitions of factor abundance – the physical definition and the price definition.
According to the physical criterion of factor abundance, in a 2x2x2 model, a country (say,
Ethiopia) is labor-abundant if (L/K)E > (L/K)SA or equivalently if (K/L)E < (K/L)SA.
According to the price criterion of factor abundance, in a 2x2x2 model, Ethiopia is said to be
labor-abundant if (w/r)E < (w/r)SA or if (r/w)E > (r/w)SA. The definition of factor abundance in
terms of physical units considers only the supply of factors. The definition in terms of relative
factor prices considers both demand and supply (since the price of a commodity or a factor is
determined by both demand and supply under perfect competition). Since we have assumed that
demand preferences are the same in both nations, the two definitions of factor abundance give
the same conclusions in our case.

Given that Ethiopia is L-abundant and South Africa is K-abundant, and that wheat is L-intensive
while cloth is K-intensive, we would have the following production possibility frontiers for
Ethiopia and South Africa (Figure 2.18). Before trade opens up between Ethiopia and South
Africa, Wheat is cheaper in Ethiopia while cloth is cheaper in South Africa. As trade opens up,
Ethiopia sells its wheat at a price above the domestic price. Similarly, South Africa will sell its
cloth with trade than without. With the assumption of zero or insignificant transportation cost,
the prices of the commodities should be equalized in the two countries.

32
Figure 2.18: Production Bias towards the Commodity Intensive in the Abundant Factor

At the same commodity price ratio (PW/PC) represented by the slope of the two parallel lines
PSAPSA and PEPE, South Africa has a production bias in favor of C and Ethiopia in has a
production bias in favor of W. This is evident from the fact that the slope of ORS (i.e., the C/W
ratio in South Africa) is greater than the slope of ORE (i.e., the C/W ratio in Ethiopia). This
holds for any common price ratio (PW/PC). This is all about the first part of the theorem.

The second part of the theorem follows from the first part and the assumption of identical
demand structure of the two countries and homothetic tastes. Given the assumption of identical
demand structure and homothetic tastes, at the same after-trade PW/PC ratio (given by the slope
of line PIPI in Figure 2.19) both countries wish to consume C and W in the same proportion.

33
Each Country Exporting the Commodity that Uses the Country’s Abundant Factor More
Intensively. Thus, South Africa which has production bias in favor of C (producing at point
PSA) will export C (and import W), thereby moving from production equilibrium PSA to
consumption equilibrium TSA. Similarly, Ethiopia which has production bias in favor of W
(producing at point PE) will export W (and import C), thereby moving from production
equilibrium PE to consumption equilibrium TE. After specialization and trade, the structure of
the quantities of the two goods available for consumption turns out to be identical in both
countries.

However, there could be differences in demand structures of the two nations as long as the
demand bias of a nation in favor of the commodity it specializes in does not offset the production
bias.The H-O theorem does not hold if the demand factors (or consumption bias) offset
production bias.

The Factor-Price Equalization Theorem

H-O model implies the factor-price equalization theorem as a corollary. This theorem states that
international trade in commodities under the assumptions of H-O model equalizes not only
commodity prices but also the relative and absolute factor prices across countries.

34
The argument of the theorem goes as follows.

Before trade, capital is cheap and labor is expensive in South Africa and vice versa in Ethiopia.
As trade opens up, the cloth production of South Africa expands and its wheat production
contracts. As a result, demand for capital increases faster than its supply because, given the
assumption of full employment, the amount of capital that is released from the contracting wheat
industry is not sufficient, as wheat production is labor intensive.

This discrepancy between supply and demand leads to increase in the price of capital (r) and a
fall in the price of labor (w). The opposite happens in Ethiopia; that is, rise price of labor (w) and
a fall in the price of capital (r). Consequently, factor prices in South Africa and Ethiopia tend to
be equal when trade opens up.

There are two forms of the factor-price equalization theorem (FPET).

1. The weak form of the FPET or the relative factor price equalization theorem states that
free trade between two countries in the H-O world will equalize relative factor prices
[i.e., (w/r)E = (w/r)SA] provided that neither country specializes completely.
2. The strong form of FPET or the absolute factor price equalization theorem states that free
trade between two countries in the H-O world will equalize absolute factor prices (w)E =
(w)SA and (r)E = (r)SA provided that neither country specializes completely.

In the pre-trade (autarky) situation, Ethiopia, which has comparative advantage in the production
of W, will have a lower PW/PC ratio or a greater PC/PW that corresponds to a lower w/r ratio.
This is given by (w/r)E and (PW/PC)E in Figure 2.20 below. South Africa, which has
comparative advantage in the production of C, will have a lower PC/PW ratio or a greater
PW/PC that corresponds to a greater w/r ratio (combination (w/r)SA and (PW/PC)SA in the
figure).

35
Figure 2.20: Relative Factor-Price Equalization

As trade opens up between the two nations, the relative price of C falls as compared to the
autarky price in Ethiopia and rises as compared to the autarky price in South Africa. With a
balanced free trade and zero transportation costs, the same good must have the same price in
both countries. That is, PC in Ethiopia is the same as PC in South Africa. The same is true for
PW. This implies that the relative price of goods is the same in both countries, i.e., PW/PC is the
same in both countries given by (PW/PC)* in the above figure. From this, it follows that the
relative price of factors is identical in both countries ((w/r)*).

Empirical Tests of the H-O Model

Since the factor-proportions theory of trade is one of the most influential ideas in international
economics, it has been the subject of extensive empirical testing. Wassily Leontief conducted the
first and most famous empirical test of the factor-proportions theory.

He tested the following hypothesis: Given the factor-proportions theory, since the U.S. was a
capital-abundant country when compared to its trading partners, it is expected that the U.S.

36
exported capital intensive goods and imported labor-intensive goods. He, then, compared the
K/L ratios of the industries that had a net trade surplus – the net exporters – to the K/L ratios of
the industries having a net trade deficit – the net importers. Leontief expected that U.S. industries
with a trade surplus (i.e., with revealed comparative advantage) would have a high K/L ratio
relative to U.S. industries with trade deficit (i.e. with revealed comparative disadvantage).

At the end of his test, what Leontief found was the reverse, i.e., industries with trade surpluses
were more labor-intensive than industries with trade deficits. The result has been called the
Leontief Paradox.

Later on, a number of possible explanations were given for Leontief’s results. Some of these are:

1. Leontief himself argued that since U.S. labor was about three times as productive as foreign
labor.

2. U.S. tastes were biased so strongly in favor of K-intensive commodities so as to result in

higher relative prices for these commodities in the U.S.

Therefore, the U.S. would export relatively L-intensive commodities.

This explanation of the Leontief’s Paradox based on a difference in tastes is unacceptable

because tastes are known to be similar across nations as the income elasticity for different classes
of goods was remarkably similar across nations.

3. A commodity might be intensive in natural resources so that classifying it as either K-

intensive or L-intensive would clearly be inappropriate.

Because Leontief used a two-factor (labor and capital) model, his results may be biased. Since
the U.S. imports many of natural resources, this would help to explain why U.S. imports are
capital-intensive.

4. U.S. trade policy may have biased the results. Many of the most heavily protected industries in
the U.S. are labor-intensive (e.g. textiles and apparel).

37
5. The Leontief’s two-factor model assumes that labor is homogeneous or that one unit of labor
is like any other unit of labor. However, much of the U.S. labor force is highly skilled or
possesses human capital (knowledge and skills).

6. There are other critics (or explanations) of Leontief’s Paradox particularly regarding the
methodology he used and the particular year he selected to be a representative.

Criticisms of H-O Theorem

H-O theory has been criticized on the following grounds: Two-by-two-by-two Model. Ohlin has
been criticized for presenting two by-two model based on oversimplified assumptions. But, as
Ohlin himself points out, it can be extended to many regions, many commodities and many
factors. Factors are not homogeneous; again, the Ohlin model assumes homogeneous production
techniques for each commodity in the two countries, Tastes and Demand Patterns not Identical,
No Constant Returns. Transport Costs influence Trade, Unrealistic Assumptions of Full
Employment and Perfect Competition.

Despite these criticisms, the H-Ohlin theory of international trade is definitely an improvement
over the classical theory as it attempts to explain the basis of international trade in the general
equilibrium setting.

2.1.5. The New/ Modern Trade Theories

As we have seen in the previous sub topics, the H-O model of international trade employs some
many assumptions some of which are really unrealistic.

From the above discussion one can conclude that relaxing the assumptions used by the H-O
model of international trade leaves the model to be valid except in some cases such as: allowing
factor intensity reversal to prevail, introducing the assumption of the increasing returns to scale
and considering the case of imperfectly competitive market structures. In this sub topics the later
assumptions will be incorporated to explain the international trade.

International Trade between Similar Countries

The Ricardian theory of international trade reveals that trade happens between countries that do
have difference in labor productivity.

38
As per the H-O model of international trade, trade happens between nations that do have
difference in resource abundance i.e. labor abundant countries trade with capital abundant
countries. However, when we look at the contemporary trade relationships between countries,
there is enormous trade among developed nations that are all capital abundant. Similarly, trade
among developing countries that are basically labor abundant is very common. The implication
of these is that trade can happen actually even among economies that are similar either in their
resource abundance and /or labor productivity. Countries may differ either in their resource
endowment or in technology and specialize in the things they do relatively well; economies of
scale (or increasing returns) can make it advantageous for each country to specialize in the
production of only a limited range of goods and services. This topic introduces the role of
economies of scale as a rationale for trade to take place between nations.

Up to now, we have assumed that markets are perfectly competitive, so that all monopoly profits
are always competed away. When there are increasing returns, however, large firms usually have
an advantage over small firms, so that markets tend to be dominated by one firm (monopoly) or,
more often, by a few firms (oligopoly). When increasing returns enter the trade picture, then,
markets usually become imperfectly competitive.

Let us begin with an overview of the concept of economies of scale and the economics of
imperfect competition. After that we will turn to models of international trade in which
economies of scale and imperfect competition play a crucial role in international trade: the
monopolistic competition model. We will also try to address the role of a different kind of
increasing returns, external and internal economies in determining trade patterns.

Economies of Scale and International Trade:

An Overview the models of comparative advantage already presented were based on the
assumption of constant returns to scale. In practice, however, many industries are characterized
by economies of scale (also referred to as increasing returns. A simple example can help convey
the significance of economies of scale for international trade. Table 2-5 shows the relationship
between input and output of a hypothetical industry.

The presence of economies of scale may be seen from the fact that doubling the input of labor
from 15 to 30 more than doubles the industry's output. In fact, output increases by a factor of

39
2.5. Equivalently, the existence of economies of scale may be seen by looking at the average
amount of labor used to produce each unit of output: if output is only 5 units of the product the
average labor input per the product is 2 hours, while if output is 25 units the average labor input
falls to 1.2 hours.

Table 2.5: The Relationships between Inputs and Output (Hypothetical Example)

why ES provide an incentive for international trade?

Imagine a world consisting of two countries, America and Britain, both of whom have the same
technology for producing the above product, and suppose that initially each country produces 10
units of the product. According to the table this requires 15 hours of labor in each country, so in
the world as a whole 30 hours of labor produce 20 units of the product. But now suppose that we
concentrate world production of the product in one country, say America, and let America
employs 30 hours of labor in the industry that produces the product. In a single country the 30
hours of labor can produce 25 units of the product. So by concentrating production of the product
in America, the world economy can use the same amount of labor to produce 25 percent more
units of the product. The above example reveals that production is more when it takes place in
America.

40
Imagine that there are many goods subject to economies of scale in production, and give them
numbers: 1, 2, 3, 4, 5, and 6. In order to take advantage of economies of scale, each of the
countries must concentrate on producing only a limited number of goods. Thus, for example,
America might produce goods 1, 3, 5 while Britain produces 2, 4, and 6. If each country
produces only some of the goods, then each good can be produced at a larger scale than would be
the case if each country tried to produce everything, and the world economy can therefore
produce more of each good. How does international trade enter the story?

Suppose that industry 1 ends up in America and industry 2 in Britain; then American consumers
of good 2 will have to buy goods imported from Britain, while British consumers of good 1 will
have to import it from America. International trade plays a crucial role: it makes it possible for
each country to produce a restricted range of goods and to take advantage of economies of scale
without sacrificing variety in consumption. Indeed, as we will see below, international trade
typically leads to an increase in the variety of goods available.

Economies of Scale and Market Structure

We did not say how this production increase was achieved whether existing firms simply
produced more, or whether there was instead an increase in the number of firms. To analyze the
effects of economies of scale on market structure, however, one must be clear about what kind of
production increase is necessary to reduce average cost. There are two essential concepts that
should be clarified:

(1) External economies of scale occur when the cost per unit depends on the size of the industry
but not necessarily on the size of any one firm.

(2) Internal economies of scale occur when the cost per unit depends on the size of an individual
firm but not necessarily on that of the industry.

External and internal economies of scale have different implications for the structure of
industries. An industry where economies of scale are purely external (that is, where there are no
advantages to large firms) will typically consist of many small firms and be perfectly
competitive.

41
Internal economies of scale, by contrast, give large firms a cost advantage over small and lead to
an imperfectly competitive market structure. Both external and internal economies of scale are
important causes of international trade.

Monopolistic Competition and Trade

Underlying the application of the monopolistic competition model to trade is the idea that trade
increases market size. By trading with each other, and therefore forming an integrated world
market that is bigger than any individual national market, nations are able to loosen these
constraints. Suppose, for instance, that there are two countries, each with an annual market for 1
million automobiles.

By trading with each other, these countries can create a combined market of 2 million autos. In
this combined market, more varieties of automobiles can be produced, at lower average costs,
than in either market alone. The monopolistic competition model can be used to show how trade
improves the tradeoff between scale and variety that individual nations face.

We will begin by showing how a larger market leads, in the monopolistic competition model, to
both a lower average price and the availability of a greater variety of goods. Applying this result
to international trade, we observe that trade creates a world market larger than any of the national
markets that comprise it.

Economies of Scale and Comparative Advantage

We have considered so far and think about how economies of scale interact with comparative
advantage to determine the pattern of international trade. Let us now imagine a world economy
consisting two countries Home and Foreign. Each of these countries has two factors of
production, capital and labor. We assume that Home has a higher overall capital-labor ratio than
Foreign, that is, that Home is the capital abundant country.

Let's also imagine that there are two industries, manufactures and food, with manufactures the
more capital-intensive industry and food the more labour – intensive product. Because Home is
capital-abundant and manufactures capital - intensive, Home would have a larger relative supply
of manufactures and would therefore export manufactures and import food.

42
Schematically, we can represent this trade pattern with a following diagram The length of the
arrows indicates the value of trade in each direction; the figure shows that Home would export
manufactures equal in value to the food it imports. If we assume that manufactures is a
monopolistically competitive sector (each firm's products are differentiated from other firms'),
Home will still be a net exporter of manufactures and an importer of food.

We can think of world trade in a monopolistic competition model as consisting of two parts.
There will be two-way trade within the manufacturing sector. This exchange of manufactures for
manufactures is called intra - industry trade. The remainder of trade is exchanges of
manufactures for food called inter - industry trade.

Trade in a world without increasing returns

In a world without economies of scale, there would be a simple exchange of manufactures for
food. But when the increasing returns to scale are taken into account, there can be exchange
within the manufactures and within food industry as shown in below figure. Since the inter
industry trade is already discussed in the H-O model of international trade, the next section is
devoted to intra- industry trade.

Intra-Industry Trade

Intra- industry trade is defined as the simultaneous import and export of commodities that belong
to the same industries.

43
Suppose now that the global manufactures industry is described by the monopolistic competition
model. Because of product differentiation, suppose that each country produces different types of
manufactures. Because of economies of scale, large markets are desirable: the foreign country
exports some manufactures and the domestic country exports some food. If domestic country is
capital abundant, it still has a comparative advantage in manufactures. It should therefore export
more manufactures than it imports if the trade in the food industry continues to be determined by
comparative advantage.

Figure: Trade with Increasing Returns and Monopolistic Competition

As indicated in above figure, if manufactures is a monopolistically competitive industry, Home

and Foreign will produce differentiated products. As a result, even if Home is a net exporter of
manufactured goods, it will import as well as export manufactures, giving rise to intra-industry
trade. The monopolistic competition model does not predict in which country firms locate, but a
comparative advantage in producing the differentiated good will likely cause a country to export
more of that good than it imports. The relative importance of intra-industry trade depends on
how similar countries are. Countries with similar relative amounts of factors of production are
predicted to have intra-industry trade.

Countries with different relative amounts of factors of production are predicted to have inter-
industry trade.

44
2.2. Evaluation of Trade Theories

The theory of comparative cost has lately been replaced by more modern theories of international
trade. This paper considers the relations between these different theories. Haberler opportunity
cost analysis emphasizes continuity with and similarity to the older doctrine by taking as data the
scales of relative prices established by the pricing process. Ohlin's general equilibrium theory is
simply a more general and explicit formulation of the opportunity-cost doctrine. Though Ohlin,
like Haberler, demonstrates that mutually beneficial trade is possible only where relative price
scales differ, he is less concerned with this result than with its underlying basis: the relative
supplies of the productive agents. Elaboration of this ultimate scarcity aspect of international
trade is what distinguishes this theory and gives it superior explanatory value. For dealing with
welfare problems, the abbreviated opportunity-cost version is handier. Both modern formulations
differ from the classical in that they assume a multiple, the latter a single-factor world.

2.3. Summary and Conclusions

To the mercantilists, stocks of precious metals represented the wealth of a nation. The
mercantilists contended that the government should adopt trade controls to limit imports and
promote exports. One nation could gain from trade only at the expense of its trading partners
because the stock of world wealth was fixed at a given moment in time and because not all
nations could simultaneously have a favorable trade balance.

Smith challenged the mercantilist views on trade by arguing that, with free trade, international
specialization of factor inputs could increase world output, which could be shared by trading
nations. 1. In this unit we have seen that relaxing most of the assumptions of the H-O-S
model of international trade remain valid except allowing factor intensity reversal and the
introduction of increasing returns to scale that lead to rejection of the model.
2. In this unit, we have also seen that trade need not be the result of comparative advantage
alone. Instead, it can result from increasing returns or economies of scale, that is, from a
tendency of unit costs to be lower with larger output. Economies of scale give countries an
incentive to specialize and trade even in the absence of differences between countries in their
resources or technology.

45
Comparative costs can be illustrated with the production possibilities schedule. This schedule
indicates the maximum amount of any two products an economy can produce, assuming that all
resources are used in their most efficient manner. The slope of the production possibilities
schedule measures the marginal rate of transformation, which indicates the amount of one
product that must be sacrificed per unit increase of another product.

Under constant-cost conditions, the production possibilities schedule is a straight line. Domestic
relative prices are determined exclusively by a nation's supply conditions. Complete
specialization of a country in the production of a single commodity may occur in the case of
constant costs.

In the real world, nations tend to experience increasing-cost conditions. Thus, production
possibilities schedules are drawn concave to the diagram's origin. Relative product prices in each
country are determined by both supply and demand factors. Complete specialization in
production is improbable in the case of increasing costs. Because Ricardian trade theory relied
solely on supply analysis, it was not able to determine actual terms of trade.

1. In order to determine the relative commodity price at which trade actually takes place, we
must introduce the offer curve of each nation. The offer curve of a nation shows how much of
its import commodity the nation requires in exchange for various quantities of its export
commodity. The offer curve of a nation is derived from the nation's production possibilities
curve, its indifference map and the various hypothetical relative commodity prices at which
trade could take place. In this unit we have seen that relaxing most of the assumptions of the
H-O-S model of international trade remain valid except allowing factor intensity reversal and
the introduction of increasing returns to scale that lead to rejection of the model.
In this unit, we have also seen that trade need not be the result of comparative advantage alone.
Instead, it can result from increasing returns or economies of scale, that is, from a tendency of
unit costs to be lower with larger output. Economies of scale give countries an incentive to
specialize and trade even in the absence of differences between countries in their resources or
technology.

46
 III. INTERNATIONAL TRADE POLICY
3.1. The Instruments of Trade Policy

As you have seen in the previous section chapter, free trade is beneficial for the vast majority of
countries. Most countries nevertheless restrict trade in various ways. This chapter outlines the
most often used instruments of trade policy, i.e. the ways in which countries can erect barriers to
trade. There are two instruments of trade policy: Tariff and Non-tariff trade policy.

3.2. Arguments in Favor of and Against Trade Protection

A policy of no restrictions on the movement of goods between countries is known as the policy
of Free Trade. Restrictions placed with a view to safeguarding home industries constitute the
policy of protection. In the words of Adam Smith, the term 'free trade' has been used to denote
"that system of commercial policy which draws no distinction between domestic and foreign
commodities and, therefore, neither imposes additional burdens on the latter, nor grants any
special favors to the former.

In short, the free trade theory is that such a policy enables every country to devote itself to those
forms of production for which it is best suited on the basis of comparative advantages.

A. Cases For Free Trade

For arguments in favor of free trade are:-

 Gains from foreign trade:

 Static gains = to welfare gains in consumption and production
 Dynamic gains impact on economic growth and economic development

B. Cases against Free Trade

The free-trade argument is, in principle, persuasive. The term 'protection' is used to denote a
policy of encouraging the home industries by the use of bounties or by the imposition of high
customs duties on foreign products. The objective is to build up great national industries even by
sacrificing utilities on the part of existing consumers.The arguments for protection are stated
below.

47
1. Infant Industry Argument

The infant industry argument rests on the following grounds: Every country has its own poten-
tialities for developing some industries in the form of labour skill, raw materials and
entrepreneurial talent. Every nation has the right to develop its potentialities or discover its latent
productive powers. It takes time for the productive elements to be developed. Labour can be
trained; raw materials can be improved; and entrepreneurs can become competent by experience.
But they should have enough time to develop and discover themselves.

2. Diversification of Industry Argument

This argument was advanced, among other writers, by Friedrich List in Germany. According to
List, a nation should have a variety of sources of production and employment. Politically it
means too much dependence on foreign trade which may be cut off during a war. Economically,
a country depending on a few industries is exposed to the danger of serious economic dislocation
in case some adverse circumstances affect such an industry. But it must be understood that this
argument cuts at the root of the principle of comparative cost according to which each country
must specialize in the production of certain articles. According to this argument a country must
produce even those articles in which it may not have comparative advantage.

3. Employment Argument

It is argued that industrial development through protection increases employment in a country.

Conversely, if protection is not given to old established industries; foreign competition may ruin
them and create unemployment in the country.

4. Conservation of National Resources Argument

The argument has some force. If a country exports its exhaustible materials in a raw-state, it
loses manufacturer's profits. It may also be seriously handicapped when such materials have been
altogether exhausted.

5. Defense Argument

Adam Smith remarked "Defense is better than opulence". It is said that essential to make a
country militarily strong though it may not be economically prosperous. Hitler preached to the

48
German nation, "Gun! Better than butter" According to this argument a country must actively
encourage the development of those industries which are essential from the point of view of
defense, even though it may result uneconomic distribution of the national resource.

6. Revenue Argument

Protection is also advocated for revenue purposes. When protective import duties are imposed,
they certainly bring in revenue to the government. But it may be pointed out that there is a
certain degree of incompatibility between the revenue and protection. If the duties are moderate,
they will yield revenue besides affording protection. It is, however, much better to advocate
protection for the sake of protecting industries rather than for raising revenues.

7. Key Industry Argument

If the industrial structure of a country is to be stable and sound, the country must develop 'key' or
basic industries; otherwise foundation of industries will have been laid on sand. Protection must
be granted to them.

8. Patriotism Argument.

Protection is advocated on patriotic grounds also. It is the duty of every citizen to use home-
made goods as far as possible.

9. Self-sufficiency Argument

Another argument in favor of protection is that we should become self-sufficient and not depend
on other countries for our necessaries.

10. Avoid unfair competition

Protection also becomes necessary against unfair competition from abroad arising from dump-
ing, depreciated exchanges, bounties, etc.

11. Economic Stability

Protection is expected to make the domestic economy immune from the destabilizing effects of
external disturbing factors.

49
3.3. Trade Policy and Economic Welfare

3.3.1. Trade policy: Tariffs and Non - Tariff Barriers

The two broader categories of barrier to free trade between countries are natural barriers and
manmade barriers. Natural barriers to trade: arise on account of the cost and the distance
involved in moving goods and services from one country to another. In short, it is the transport
cost. Manmade barriers is further classified into tariff and non-tariff (hidden) barriers.

Tariff and Its Effects

What is tariff?

Tariffs are essentially the taxes or duties imposed on the imported or exported goods. On the
other hand, tariff refers to a tax or duty levied by the government of a country on goods and
services entering foreign trade. It is simply a price that any importer has to pay for his product to
enter the country.

Types of tariffs

A specific tariff: It is expressed in terms of a fixed amount of money per physical unit of the
imported product. For example, a U.S. importer of a German computer may be required to pay a
duty to the U.S. government of $100 per computer, regardless of the computer's price.

An ad valorem (of value) tariff: it much like a sales tax is expressed as a fixed percentage of
the value of the imported product. Suppose that an ad valorem duty of 15 percent is levied on
imported trucks. If U.S, importer of a Japanese truck valued at $20,000 would be required to pay
a duty of $3,000 to the government ($20,000 X 15% = $3,000).

A compound tariff: it is a combination of specific and ad valorem tariffs. For example, an

Ethiopia importer of a coffee might be required to pay a duty of $20 plus 5 percent of the value
of the coffee. What are the relative merits of specific, ad valorem, and compound tariffs?

Specific tariffs:

As a fixed monetary duty per unit of the imported product, a specific tariff is relatively easy to
apply and administer. Its protective effect will decline in periods of inflation. A rising price

50
reduces the protective effect of specific tariffs. A specific tariff also will severely restrict imports
of lower priced items within a product category

A main disadvantage of a specific tariff is that the degree of protection it affords domestic
producers varies inversely with changes in import prices. The result is to encourage domestic
firms to produce less expensive goods, for which the degree of protection against imports is
higher. On the other hand, a specific tariff has the advantage of providing domestic producers
more protection during a business recession, when cheaper products are purchased.

Ad valorem tariffs

Usually lend themselves more satisfactorily to manufactured goods, because they can be applied
to products with a wide range of grade variations. As a percentage applied to a product's value,
an ad valorem tariff can distinguish among small differentials in product quality to the extent that
they are reflected in product price.Under a system of ad valorem tariffs, a person importing a
$20,000 Honda would have to pay a higher duty than a person importing a $19,900 Toyota.
Under a system of specific tariffs, the duty would be the same.Another advantage of an ad
valorem tariff is that it tends to maintain a constant degree of protection for domestic producers
during periods of changing prices.If the tariff rate is 20 percent ad valorem and the imported
product price is $200, the duty is $40. If the product's price increases, say, to $300, the duty
collected rises to $60;

A disadvantage of an ad valorem tariff is that it creates opportunities for cheating through what is
called false invoicing or transfer pricing. When a duty is imposed on a commodity at the time of
its leaving the national border, it is called 'export duty' and when it is levied on the goods
entering the national border, it is called 'import duty'. Import duties are more common than
export duties, so much so that tariffs are often identified with import duties. Tariffs are aimed at
altering the import prices (or export prices) so as to regulate the volume of imports (or of
exports).

The effects of import tariff for small country case

Tariff is an important tool of commercial policy. On the one hand, it limits consumers’ choice by
forcing them to cut consumption of the goods they like and, on the other; it shifts the use of

51
resources from one use to another. The effect of tariffs is to change relative prices of goods,
services and factors of production. To measure the effects of a tariff on a nation's welfare,
consider the case of a nation whose imports constitute a very small portion of the world market
supply. This small nation would be a price taker, facing a constant world price level for its
import commodity. This is not a rare case; many nations are not important enough to influence
the terms at which they trade. We assume that the country in question say A is small, such that
domestic producers cannot affect the world market price, pw.

In the left panel of Figure 3.1, we show Country A’s domestic demand (D) and supply (S) curves
for a particular commodity, say, wheat. If trade is free, wheat will be imported into Country A at
the prevailing world price, Pw. Total supply (domestic output plus imports) equals total demand
at that price.When country is small, a tariff it imposes cannot lower the foreign price of the good
it imports. As a result, the price of the import rises from Pw to Pw + t and the quantity of imports
demanded falls from D1 -S1 to Price, D2-S2.

Figure 3.1: A tariff in small country

52
In Figure 3.1, the small nation before trade produces at market equilibrium point of intersection
as determined by the intersection of its domestic supply and demand schedules.

Note that: For a small nation, a tariff placed on an imported product is shifted totally to the
domestic consumer via a higher product price.

Consumer surplus falls as a result of the price increase. The small nation’s welfare decreases by
an amount equal to the protective effect and consumption effect, the so-called deadweight losses
due to a tariff. Begin by considering the effects of a tariff imposed on a single commodity.
Assume that the industry involved is a very small part of the total economy. It is so small, in fact,
that changes in this industry have negligible effects on the rest of the economy, and these effects
can be ignored. We call this framework partial equilibrium analysis. Also, we consider the case
of a competitive market, where an industry supply curve represents the aggregate response of
many individual firms to the market price. No single firm is big enough to affect the market price
by its own decision to increase or decrease output.

Example:In the left panel of Figure 3.2, we show Country A’s domestic demand (D) and supply
(S) curves for a particular commodity, say, wheat. If trade is free, wheat will be imported into
Country A at the prevailing world price, Pw. At that price, Country A’s total consumption will
be 100, its production will be 60, and imports will make up the difference, 40. Total supply (60
of domestic output plus 40 of imports) equals total demand (100) at that price.

Note that: there is no demand for imports at a price of wheat greater than the autarky price, PA.

At a price lower than PR where the domestic supply curve cuts the vertical axis and the quantity
supplied equals zero, then the import demand curve is the same as the market demand curve. At
prices between PA and PR the quantity of imports demanded is simply the difference between
the quantity demanded and the quantity supplied domestically. Now suppose that Country A
imposes a tariff, equal to T or $.50 per on imports of wheat. The immediate result of the tariff is
that the price of wheat in Country A will rise by the amount of the tariff to PT.

In this section of the chapter we assume that the world price of wheat remains unchanged when
Country A imposes its tariff. That is, we assume that Country A is a small country whose actions
will not affect the world market. The increase in price has a number of effects that can

53
conveniently be examined in Figure 3.2 The first effect is that the consumption of wheat is
reduced from 100 to 95. The second effect is that domestic output rises from 60 to 70. Domestic
producers do not pay the import tariff, of course, and the higher domestic price gives them an
incentive to increase their output, as indicated by a movement along the supply curve.

The third effect is that imports fall from 40 to 25.Both the fall in consumption and the rise in
production cut into the previous level. The lost consumers’ surplus, a + b + c + d, is divided
between the government, which takes in tariff revenues of area c, and the domestic industry,
which receives additional producers’ surplus of area a. Triangles b and d are deadweight losses
of imports of wheat.

Note that if the tariff were large enough to raise the price to PA imports would fall to zero.
Domestic producers would supply the entire demand. This would be a prohibitive tariff.We can
also use Figure 3.2 to show the welfare gains and losses that result from the tariff. To show these
gains and losses, we use the concepts of consumers’ surplus and producers’ surplus.First, we
recognize that the area under the demand curve shows what consumers are willing to pay for a
product.

At the world price PW this measure of consumers’ surplus is the triangle PKNPW, which is the
total area under the demand curve, PKNQ4O, less the amount spent on wheat,
PWNQ4O.Imposition of the tariff reduces the consumers’ surplus to PKMPT, a reduction equal
to the area of the trapezoid PWPTMN. That trapezoid includes the separate areas a, b, c, and d.
For those who like to confirm such calculations numerically, the area is $4,875 for the values
show in the diagram. Although consumers lose from the imposition of the tariff, domestic
producers gain and revenues to rise by areas a, b, and f

Not all of that additional revenue represents higher profits, though, because domestic costs of
production rise too. In a competitive industry where the supply curve is based upon the marginal
cost of output of the firms in the industry, the extra cost of producing Q1Q2 of output is areas b
+ f. Therefore, the change in producers’ surplus is the change in revenue minus the change in
cost, area a, which equals $3,250 for the numerical values shown.

54
We define producers’ surplus as the difference between the price that a supplier is willing to
accept compared to the price actually received in the market. Because the price a firm is willing
to accept is given by the supply curve, area e represents the initial value of producers’ surplus.
When price rises to PT, then the producers’ surplus triangle becomes e + a, and the change in
producers’ surplus is represented by the trapezoid a. Not only do domestic producers gain, but
the government also gains tariff revenue equal to area c. The tariff revenue is equal to the tariff,
T, times the imports on which the tariff is collected, Q2Q3, which equals $1,250 for the
numerical values shown. It is a transfer from consumers to the government.From a national point
of view, therefore, areas a and c are not net losses; they are transfers from consumers to
producers and to the government, respectively. Areas b and d are lost to consumers, but they are
not gained by any other sector.

These areas therefore represent the net welfare loss resulting from the tariff, sometimes called
the deadweight loss.

55
The numerical values of areas b and d are $250 and $125, respectively, giving a total deadweight
loss of $375. The net effects of a tariff that we have identified in the left panel of Figure 5.2 can
also be derived in the right panel. The apparent loss in consumers’ surplus that we infer from the
import demand curve is given by areas c + b + d. The same deadweight loss, areas b + d, arises
as the quantity of imports falls.

The effects of tariff for large country case: Tariff Welfare Effects: Large-Nation Model

Now consider the case of an importing nation that is large enough so that changes in the quantity
of its imports, by means of tariff policy, influence the world price of the product. This large-
nation case could apply to the United States, which is a large importer of autos, steel, oil, and
consumer electronics, and to other economic giants such as japan and the European Union. For a
large nation, a tariff on an imported product may be partially shifted to the domestic consumer
via a higher product price and partially absorbed by the foreign exporter via a lower export price.

Figure 3.3 shows the foreign country’s demand and supply for a given product on the left side of
the graph and to the right is the home (tariff imposing) country’s demand for and supply of same
(homogeneous) product. PH and PF are the pre-trade equilibrium prices in the home and foreign
countries respectively.

The price deferential (PH – PF) induces trades between the two countries letting the home
country importer and the foreign country an exporter of the product. When international price is
equalized at Pw (world price), the foreign country’s exports (S0FD0F) are equal to the home
countries imports (S0D0 = JM).

The free trade price is therefore Pw at which the home country’s imports are JM. Transport costs
and tariffs are assumed to be zero. Now let us introduce tariffs. If the rate of import tariff per unit
of imported product is equal to the distance between Pt and Pw, this imposition of tariff by the
home country on the imported product will cause the following effects on the importing country.

56
1. Price effect

The immediate effect of imposition of tariff is to raise the price of both the imported product and
the domestically produced product (import replacement product) in the home country.

2. Consumption effect

The reduction in consumption due to tariff is equal to (D0D1 = ML). This is called the
consumption effect.

3. Production (Import substitution), or protective effect

In the figure the distance S0S1 = JK is a measure of this import substitution. Tariff reduces the
import competing goods thus affording protection to the domestic producer.

Domestic production increased as shown above as a result of the imposition of tariff.

4. Revenue Effect

57
The government derives revenue from the tariff which is measured by the quantity of the imports
multiplied by the rate of tariff.

5. Balance of trade effect

Out of the total import cuts from S0D0 to S1D1, the reduction amounting S0S1 = JK is due to
production (import substitution or protective) effect of tariff and the other D1D0 = LM is due to
consumption effect of tariff.

6. Economic welfare effect

The economy of a country is composed of three parties, namely, consumers, producers and the
government. In considering the economic welfare effect of tariffs on the imposing country, we
need to find out whether the welfare of each of the groups in the economy has gone up or down.

a. welfare effect of tariffs on consumers

This implies that consumers will loss a welfare level equal to the area PwPtHM = a + b + c + d.
Thus, tariffs decrease the welfare level of consumers through increased prices and decrease in
quantity demand (consumed).

b. welfare effect of tariff on producers

This gain in producers’ surplus is part of the loss in consumers’ surplus. Moreover, the gain in
producers’ surplus is due to the protective (production or import substitution) effect of tariff.

c. welfare effect of tariff on government

This revenue is also part of the welfare loss by consumers.

d. Overall welfare effect of tariff

In this way income is transferred from the consumers to producers and the government. This
effect of distribution of income is called the distributive effect. However, There is a dead weight
loss, also termed as the cost of tariff. b + d. It is the net welfare loss to the economy due to tariff.

7. The Terms of Trade Effect.

58
Tariff reduces the volume of trade and the terms of trade will improve for the country imposing
the tariff.

8. Effect on National Income.

If a country is facing unemployment problem, imposition of tariff increase employment and thus
increases income.

3.3.2. Non-tariff barriers

Tariffs are the simplest trade policies, but in the modern world most government intervention in
international trade takes other forms, such as export subsidies, import quotas, voluntary export
restraints, and local content requirements.

There are several reasons suggested for why countries use non-tariff barriers instead of tariff.

1. Political reason

Even though non-tariff barriers result similar consumers’ welfare loss like tariff, the non-tariff
barriers’ effect tends to be more remote and less visible. Politicians may therefore perceive non-
tariff barriers as being more acceptable to the voting public.

2. Certainty of restrictive impact of non-tariff barriers

The restrictive impact of non-tariff barriers is relatively more certain as a protection instrument
than tariff.

3. Non-tariff barriers are not covered by rule of WTO (former GATT)

Many nations have adopted non-tariff barriers because they are not covered by the main body of
rules of conduct in international trade.

A. Import quota

Quota is a direct limitation of the physical quantity of exports and imports permitted in the
country. An import quota is a physical restriction on the quantity of goods that may be imported
during a specific time period

59
Types of Quotas

i. Unilateral quotas: Import quotas are generally imposed unilaterally by the home government,
without prior negotiation or consultation with other nations. They are levied and administered
exclusively by the importing nation.

ii. Global quota: One way of administering import limitations is through a global quota. This
technique permits a specified number of goods to be imported each year, but does not specify
where the product is shipped from or who is permitted to import. In practice, the global quota
becomes unwieldy because of the rush of both domestic importers and foreign exporters to get
their goods shipped into the country before the quota is filled.

iii. Selective ( allocated) quota: To avoid the problems of a global quota system, import quotas
are usually allocated to specific countries; this type of quota is known as a selective quota.
Bilateral quotas imply mutual agreement between countries through negotiations.

iv. Mixing or indirect quotas

In this case the domestic producers are asked to use a fixed proportion of imported and domestic
materials used in producing their products. The quota is fixed not in absolute forms but in
percentage forms.

Tariffs versus quotas

The effects of quotas are similar to those of tariffs, but there are also substantive differences
between the two which are worth examining.

Similarities

They both have the same objectives like protecting domestic industries, correcting BOP, and
expand domestic employment and economic activities. Since both quota and tariffs raise the
import price and reduce the import quantity they produce similar effects on consumption,
production, trade balance, TOT, national income redistribution, factor movements, economic
growth and economic welfare.

Differences

60
Tariffs bring revenue to the government whereas quotas do not. Tariff revenues can be used for
investment on social services, but the quota profits going to importers may not contribute to net
social welfare. Distribution of import licenses (associated with quota) may give rise to corruption
and bribery on the part of government. Import tariffs do not create such problems or even if they
do the degree is small.

Quotas could be more effective than tariffs particularly when the domestic demand elastic and
supply curves for the imported goods are inelastic. As figure 3.4 indicates the demand elastic and
supply curves are perfectly inelastic. A rise in the price of the commodity from P0 (free trade
price) to P1 (price after tariff) does not bring any change in the quantity of import. The import
quantity before and after tariff are equal. The area of rectangle R, but it has failed to bring
protection effect. Import quotas, are therefore, more effective in protecting domestic industries
that produce products with inelastic demand and supply behavior.

The TOT effects of tariffs are determined or predictable, but those resulting from quotas are
unpredictable.

Sd0 + Import
Price
Sd0 = Sd1
Import after Tariff

D1

P1
Tariff
R
P0 D0

Free trade import

O Quantity

Figure 3.4 Tariffs and inelastic supply and demand conditions

B. Subsidies

National governments sometimes grant subsidies to domestic producers to help improve their
trade position. Governments wanting to see certain domestic industries expand may provide

61
subsidies to encourage their development. The overall result is to permit the producer a cost
advantage that would not otherwise exist. For purposes of our discussion, two types of subsidy
can be distinguished: a domestic subsidy, which is sometimes granted to producers of import-
competing goods, and an export subsidy, which is made to producers of goods that are to be sold
overseas.

i. Domestic Subsidy

Given a free-trade price of Pw per ton, the home country consumes Q3 tons of steel, produces
Q0 tons, and imports Q3-Q0 tons. suppose the home country’s government grants them a
production subsidy of Ps-Pw per ton of steel.

The cost advantage made possible by the subsidy results in a shift in the domestic supply curve
from SS0 to SS1. Domestic production expands from Q0 to Q1 tons, and imports fall from Q3-
Q0 to Q3-Q1 tons.

These changes represent the subsidy's trade effect.

Price of steel

S0

S1

Subsidy
A
B
Sw

PD Dd
O Q0 Q1 Q3 Quantity of steel

Figure 3.5: Economic effect of domestic subsidy

Ps

The subsidy also affects the national welfare of the home country. According to Figure 3.5, the
subsidy permits home country output to rise from Q0 to Q1 tons. A subsidy tends to yield the
same result for domestic producers as does an equivalent tariff or quota, but at a lower cost in

62
terms of national welfare. Subsidies are not free goods, however, for they must be financed by
someone. The direct cost of the subsidy is a burden that must be financed out of tax revenues
paid by the public. Moreover, when a subsidy is given to an industry, it is often in return for
accepting government conditions on key matters (such as employee compensation levels).

ii. Export Subsidy

An export subsidy is a payment to a firm individual that ships a good abroad. Like a tariff, an
export subsidy can be either specific (a fixed sum per unit) or ad valorem (a proportion of the
value exported). When the government offers an export subsidy, shippers will export the good up
to the point where the domestic price exceeds the foreign price by the amount of the subsidy. The
granting of an export subsidy yields two direct effects for the home economy: a terms-of-trade
effect and an export revenue effect.

Should the foreign demand for exports be relatively elastic, so that a given percentage drop in
foreign price is more than offset by die rise in export volume, the home nation's export revenues
would increase.

3.4. Optimal Trade Policy Intervention

A tariff always improves the terms of trade of a large country but at the same time distorts
production and consumption. This appendix shows that for a sufficiently small tariff, the terms of
trade gain is always larger than the distortion loss. Thus there is always an optimal tariff that is
positive. To make the point, we focus on the case where all demand and supply curves are linear,
that is, are straight lines.

3.5. The Process of Trade Liberalization

Trade liberalization is the reverse process of protectionism. After previous protectionist

decisions, trade liberalization occurs when governments decide to move back toward free trade.
Trade liberalization may take place unilaterally Extensive trade liberalization that occurred
among the richer countries in the second half of the 20th century was however reciprocal and
multilateral. Countries’ governments reciprocated each other’s liberalization decisions, and the
liberalization was non-discriminatory in applying to all liberalizing trading partners.

63
The trade liberalization was accompanied by liberalization of international capital markets and
by substantial international migration, both legal and illegal.

3.6. The Political Economy of Protection

A political argument for free trade reflects the fact that a political commitment to free trade
may be a good idea in practice even though there may be better policies in principle. Economists
often argue that trade policies in practice are dominated by special-interest politics rather than
consideration of national costs and benefits. Economists can sometimes show that in theory a
selective set of tariffs and export subsidies could increase national welfare, but in reality any
government agency attempting to pursue a sophisticated program of intervention in trade would
probably be captured by interest groups and converted into a device for redistributing income to
politically influential sectors. If this argument is correct, it may be better to advocate free trade
without exceptions, even though on purely economic grounds free trade may not always be the
best conceivable policy.

National Welfare Arguments against Free Trade

Most tariffs, import quotas, and other trade policy measures are undertaken primarily to protect
the income of particular interest groups. Politicians often claim, however, that the policies are
being undertaken in the interest of the nation as a whole, and sometimes they are even telling the
truth. Although economists often argue that deviations from free trade reduce national welfare,
there are, in fact, some theoretical grounds for believing that activist trade policies can
sometimes increase the welfare of the nation as a whole.

One argument for deviating from free trade comes directly out of cost-benefit analysis: for a
large country that is able to affect the prices of foreign exporters, a tariff lowers the price of
imports and thus generates a terms of trade benefit. This benefit must be set against the costs of
the tariff, which arise because the tariff distorts production and consumption incentives. It is
possible, however, that in some cases the terms of trade benefits of a tariff outweigh its costs, so
there is a terms of trade argument for a tariff.

The Domestic Market Failure: Argument against Free Trade

64
Leaving aside the issue of the terms of trade, the basic theoretical case for free trade rested on
cost-benefit analysis using the concepts of consumer and producer surplus. Many economists
have made a case against free trade based on the counterargument that these concepts, producer
surplus in particular, do not properly measure costs and benefits.

There are certain reasons why the producer surplus might not properly measure the benefits of
producing a good: These include the possibility that the labor used in a sector would otherwise
be unemployed or underemployed, the existence of defects in the capital or labor markets that
prevent resources from being transferred as rapidly as they should be to sectors that yield high
returns, and the possibility of technological spillovers from industries that are new or particularly
innovative.

3.7. Intellectual Property and Intellectual Property Rights

Intellectual property (IP) is a term referring to creation of the intellect (the term used in studies
of the human mind) for which a monopoly (from Greek word monos means single polein to sell)
is assigned to designated owners by law. Some common types of intellectual property rights
(IPR), in some foreign countries intellectual property rights is referred to as industrial property,
copyright, patent and trademarks, trade secrets all these cover music, literature and other artistic
works, discoveries and inventions and words, phrases, symbols and designs. Intellectual Property
Rights are themselves a form of property called intangible property.

In September 1985, the United States negotiated a free trade agreement with Israel. This was the
first bilateral trade agreement signed by the United States. It provided for bilateral reductions in
tariff and nontariff barriers to trade in goods between the two countries. Trade in services was
also liberalized, and some provisions were made for the protection of intellectual property rights.

The aim of the Uruguay Round was to establish rules for checking the proliferation of the new
protectionism and reverse its trend; bring services, agriculture, and foreign investments into the
negotiations; negotiate international rules for the protection of intellectual property rights; and
improve the dispute settlement mechanism by ensuring more timely decisions and compliance
with GATT rulings.

65
3.8. Summary and Conclusions

 Tariffs are essentially the taxes or duties imposed on the imported or exported goods.
 The two broader categories of barrier to free trade between countries are natural barriers
and manmade barriers. For a small nation, a tariff placed on an imported product is
shifted totally to the domestic consumer via a higher product price. These areas therefore
represent the net welfare loss resulting from the tariff, sometimes called the deadweight
loss.
 Quota is a direct limitation of the physical quantity of exports and imports permitted in
the country.
 Quotas could be more effective than tariffs particularly when the domestic demand elastic
and supply curves for the imported goods are inelastic.
 This appendix shows that for a sufficiently small tariff, the terms of trade gain is always
larger than the distortion loss.
 A political argument for free trade reflects the fact that a political commitment to free
trade may be a good idea in practice even though there may be better policies in
principle.
 Trade liberalization is the reverse process of protectionism. After previous protectionist
decisions, trade liberalization occurs when governments decide to move back toward free
trade.
 In September 1985, the United States negotiated a free trade agreement with Israel. This
was the first bilateral trade agreement signed by the United States.

66
 IV. INTERNATIONAL TRADE AND ECONOMIC DEVELOPMENT

4.1. Trade Theory and Economic Development

In fact international trade may maximize welfare of developing nations in the short term.
However, these nations believe that this pattern of specialization and trade leads them to a
subordinate position with developed nations and keeps them from reaping the dynamic benefits
of industries and from maximizing their welfare in the long-run. The dynamic benefits resulting
from industrial production includes a more trained labor force, more innovations, higher and
more stable prices for the nation’s exports, and higher income for citizens. Therefore all or most
of these dynamic benefits accrue to developed nations, leaving developed nations poor,
undeveloped and dependent.

This belief is reinforced by the observation that all developed nations are primarily industrial
while all developing nations are primarily agricultural. Thus developing nations attack traditional
trade theory as completely static and irrelevant to the development process. As a result
developing nations demand changes in the pattern of trade and reform of the present international
economic system to take in to consideration their special development needs.

Traditional trade theory can readily be extended to incorporate changes in factor supplies,
technology and tastes by the technique of comparative statics. This may indicate that a nation’s
pattern of development is not determined once and for all, but must be recomputed as underlying
conditions change or is expected to change over time. Therefore developing nations are not
necessarily or always relegated by traditional trade theory to export mostly primary commodities
and import mostly manufactured products.

4.2. Beneficial Effects of Trade

Even though international trade cannot in general be expected to be an “engine of growth” today,
there are still many ways (besides the static gains from comparative advantage) in which it can
contribute to the economic growth of today’s developing nations. Haberler, among others, has
pointed out the following important beneficial effects that international trade can have on
economic development:

(1) Trade can lead to the full utilization of otherwise underemployed domestic resources.

67
That is, through trade, a developing nation can move from an inefficient production point inside
its production frontier, with unutilized resources because of insufficient internal demand, to a
point on its production frontier with trade. For such a nation, trade would represent a vent for
surplus, or an outlet for its potential surplus of agricultural commodities and raw materials.

This has indeed occurred in many developing nations, particularly those in Southeast Asia and
West Africa.

(2) By expanding the size of the market, trade makes possible division of labor and economies of
scale.

This is especially important in the production of light manufactures in small economies in the
early stages of development.

(3) International trade is the vehicle for the transmission of new ideas, new technology, and new
managerial and other skills.

(4) Trade also stimulates and facilitates the international flow of capital from developed to
developing nations. In the case of foreign direct investments, where the foreign firm retains
managerial control over its investment, the foreign capital is likely to be accompanied by foreign
skilled personnel to operate it.

(5) In several large developing nations, such as Brazil and India, the importation of new
manufactured products stimulated domestic demand until efficient domestic production of these
goods became feasible.

(6) International trade is an excellent antimonopoly weapon because it stimulates greater

efficiency by domestic producers to meet foreign competition. This is particularly important to
keep low the cost and price of intermediate or semi-finished products used as inputs in the
domestic production of other commodities.

4.3. Alternative Trade Strategies

Economists and policymakers in the developing countries have long agreed on the role of
government in providing infrastructure, promoting market efficiency, and maintaining stable
macroeconomic policies. But they have disagreed on policies toward trade and industry.

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The form of government intervention in this area is the distinguishing feature of alternative
development strategies. Trade strategy has a great influence on industrial performance and
economic development. For analytical convenience, trade strategies can be broadly divided into
two groups, outward oriented and inward oriented.

 In principle, the distinction between an inward-oriented and an outward-oriented strategy

is straightforward, a matter of the effective protection provided to production for
domestic markets as compared with export markets. An attempt is made here to classify
the orientation of a country's trade strategy by combining the following quantitative and
qualitative indicators: Effective rate of protection. The higher for the effective protection
for domestic markets, then greater the bias toward import substitution.
 Use of direct controls such as quotas and import licensing schemes. The greater the
reliance on direct controls on imports, the more inward oriented the economy.
 Use of export incentives.
 Degree of exchange rate overvaluation. Inward orientation generally leads to an
overvaluation of the exchange rate.

Inward - and outward - Looking strategies

An outward-oriented strategy is one in which trade and industrial policies do not discriminate
between production for the domestic market and exports, or between purchases of domestic
goods and foreign goods. Because it does not discourage international trade, this
nondiscriminatory strategy is often (somewhat inaptly) referred to as an export promotion
strategy. Outward orientation links the domestic economy to the world economy. An inward
oriented strategy is one in which trade and industrial incentives are biased in favor of production
for the domestic over the export market. This approach is well known as the import substitution
strategy.

Thus, inward-oriented regimes are generally characterized by high levels of protection for
manufacturing, direct controls on imports and investments, and overvalued exchange rates.

4.4. Trade Strategies and Economic Performance

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The links between trade strategy and macroeconomic performance are not entirely clear. Does
outward orientation lead to better economic performance, or does superior economic
performance pave the way for outward orientation? The economic performance of the outward-
oriented economies has been broadly superior to that of the inward oriented economies in almost
all respects.

Outward orientation encourages efficient firms and discourages inefficient ones. And by creating
a more competitive environment for both the private and public sectors, it also promotes higher
productivity and hence faster economic growth. Economies that have followed inward-oriented
trade policies have performed poorly. Many arguments for industrialization through import
substitution have been advanced at various times. They are questionable, however, for several
reasons. For example, suppose that export pessimism were justified, in the sense that when a
country expanded its exports of a primary commodity, the price fell in world markets.

The appropriate policy response would then be to levy an export tax on that commodity, not
provide blanket import protection for the industrial sector as a whole. Or suppose that the infant
industry argument applies and that some sort of government assistance is therefore in order. A
policy of restricting imports is unlikely to be the best answer. Subsidies directed at the source of
any external benefits avoid the costs of protecting an entire industry from import competition.

The new protectionism in some industrial countries raises an important question for developing
countries: can an outward-oriented strategy be successfully adopted in these adverse
circumstances? Protection by industrial countries reduces the gains from trade both for
themselves and for the developing countries, but developing countries may only make matters
worse by turning inward. In other words, however protectionist the industrial countries, from an
economic standpoint the best choice for developing countries is an outward-oriented strategy.
But as protection increases, such an orientation becomes much more difficult politically.

Note that outward-oriented policies involving export subsidies are increasingly threatened by
countervailing actions by some industrial countries. This tilts the balance even more in favor of
the policy which, on economic grounds, is in any case the better one: import liberalization
combined with currency devaluation, rather than protection offset by export subsidies.

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Often countries such as Korea have adopted the second approach for their transition from
inward- to outward-oriented policies, and it is still in use in such countries as Brazil and Mexico.
The evidence in favor of outward-oriented over inward-oriented policies may be convincing, but
the issue of how an economy may be successfully moved from one to the other is a separate
question. Recent experience in Argentina, Chile, and Uruguay suggests that the transition to
outward-oriented policies should be carefully phased.

4.5. Export Pessimism and the Prebisch – Singer Thesis

There is empirical evidence related to the fact that the terms of trade have been continuously
moving against the developing countries. On the basis of exports statistics concerning the United
Kingdom between 1870 and 1940, Raul Prebisch demonstrated that the terms of trade had
secular tendency to move against the primary products and in favor of the manufactured and
capital goods. This viewpoint has been strongly supported by H. W. Singer. The essence of
Prebisch-Singer thesis is that the peripheral or LDC’s had to export large amounts of their
primary products in order to import manufactured goods from the industrially advanced
countries.

The deterioration of terms of trade has been a major inhibitory factor in the growth of the LDC’s.
Prebisch and Singer maintain that there has been technical progress in the advanced countries,
the fruit of which have not percolated to the LDC’s. In addition, the industrialized countries have
maintained a monopoly control over the production of industrial goods. They could manipulate
the prices of manufactured goods in their favor and against the interest of the LDC’s.

Except the success of OPEC in raising the prices of crude oil since mid-1970’s, there has been a
relative decline in the international prices of farm and plantation products, minerals and forest
products. Consequently, the terms of trade have remained unfavorable to the developing
countries.

4.6. Trade, the Environment, and Natural Resources

Economic growth resulting from trade expansion can have an obvious direct impact on the
environment by increasing pollution or degrading natural resources. In addition, trade
liberalisation may lead to specialization in pollution-intensive activities in some countries if

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environmental policy stringency differs across countries the so-called pollution haven
hypothesis. However, increased trade can in turn, by supporting economic growth, development,
and social welfare, contribute to a greater capacity to manage the environment more effectively.

More importantly, open markets can improve access to new technologies that make local
production processes more efficient by diminishing the use of inputs such as energy, water, and
other environmentally harmful substances. Similarly, trade and investment liberalisation can
provide firms with incentives to adopt more stringent environmental standards. As a country
becomes more integrated within the world economy, its export sector becomes more exposed to
environmental requirements imposed by the leading importers. Changes needed to meet these
requirements, in turn, flow backwards along the supply chain, stimulating the use of cleaner
production processes and technologies.

How can policymakers optimally combine trade and the environment policies? Effective
environmental policies and institutional frameworks are needed at the local, regional, national,
and international levels. The impact of trade liberalisation on a country’s welfare depends on
whether appropriate environmental policies are in place within the country in question (e.g.
correctly pricing exhaustible environmental resources). Stringent environmental policies are
compatible with an open trade regime as they create markets for environmental goods that can
subsequently be exported to countries that follow suit on environmental standards the so-called
first-mover advantage. This is especially true for complex technologies such as renewable
energies.

4.7. Current Problems Facing the Developing Countries

In this section, we examine the most serious problems facing developing countries today. These
are:

(1) The conditions of stark poverty prevailing in many countries, particularly those of sub-
Saharan Africa;

(2) The unsustainable foreign debt of some of the poorest developing countries; and

(3) The remaining trade protectionism of developed countries against developing countries’
exports.

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4.8. Summary and Conclusions

 Traditional trade theory can readily be extended to incorporate changes in factor supplies,
technology and tastes by the technique of comparative statics.
 Even though international trade cannot in general be expected to be an “engine of
growth” today, there are still many ways (besides the static gains from comparative
advantage) in which it can contribute to the economic growth of today’s developing
nations.
 Trade strategy has a great influence on industrial performance and economic
development. For analytical convenience, trade strategies can be broadly divided into two
groups, outward oriented and inward oriented.
 The economic performance of the outward-oriented economies has been broadly superior
to that of the inward oriented economies in almost all respects.
 Outward orientation encourages efficient firms and discourages inefficient ones. And by
creating a more competitive environment for both the private and public sectors, it also
promotes higher productivity and hence faster economic growth. The essence of
 Prebisch-Singer thesis is that the peripheral or LDC’s had to export large amounts of their
primary products in order to import manufactured goods from the industrially advanced
countries.
 Economic growth resulting from trade expansion can have an obvious direct impact on
the environment by increasing pollution or degrading natural resources.
 In addition, trade liberalisation may lead to specialization in pollution-intensive activities
in some countries if environmental policy stringency differs across countries the so-called
pollution haven hypothesis.

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V. INTERNATIONAL TRADE INSTITUTIONS AND REGIONAL ECONOMIC
ARRANGEMENTS
5.1. Historical Background: From the General Agreement on Tariffs and Trade
The GATT was progressively expanded, and became the most important multilateral trade
institution in the world up to the mid 1990’s. Between 1947 and 1994, the GATT promoted 8
rounds of multilateral trade negotiations. Most countries have different levels of protection,
maintaining the lowest level for partners in trade blocs or friends, and less favorable
circumstances for others. The GATT allows such trading blocs when their preferential treatment
applies to substantially all trade among the partners.

The WTO came into existence on the conclusion of the Uruguay Round of GATT on 15 April
1994. It succeeded the GATT which was a forum where the member countries discussed and
found out solutions to the problems confronting the world trade. The last and most important
GATT agreement took place between 1986 and 1994 and involved 123 countries; it came to be
known as the “Uruguay round”

Objectives of the WTO

The objectives of the WTO have been spelt out in the preamble to the WTO Agreements as
follows.

1. In the field of trade and economic development, its relations will be guided by the following:-
Raising the standard of living, Achieving full employment and increasing the volume of real
income and effective demand, Expanding the production and trade in goods and services

2. towards the fulfillment of the overall objective of sustainable development, to ensure the
optimal use of world’s resources by: Promoting the protection and preservation of environment
and Augmenting resources commensurate with the respective needs and concerns at different
levels of economic development

3. for ensuring that the developing countries, particularly the poorest countries, may get a share
in the growth international trade consistent with their needs of economic development.

4. for the achievements of these objectives to enter into mutually beneficial arrangements aiming
at reduction of barriers and elimination of discrimination in international trade

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5. Based on the past agreements and efforts and other results, to develop a more viable and
durable multilateral trading system

6. for coordinating policies in the field of trade, environment and economic development to take
effective steps.

Functions of the WTO

The WTO has been performing the following functions.

 It has been providing a forum for negotiations between the member countries on matters
of trade relations and terms
 It has been providing a framework for the implementation of the agreements arrived at as
a result of the negotiations
 It has been providing facilities for the administration, implementation and operation of
the terms of the General Agreements and Multilateral Trade Agreements and Plurilateral
Trade Agreements pertaining to trade in civil aircraft, dairy products, bovine meat, and
government procurement
 It has been administering the Understanding on Rules and Procedures governing the
Settlement of Disputes
 It has been offering all cooperation to the IMF and the IBRD(international bank for
Reconstruction and development) and its affiliates in making the global economic policy
more coherent.

The difference between WTO and GATT

The WTO is different from the GATT in the following respects:-

 It has a legal status which the GATT did not have. WTO has been established under an
international treaty ratified by the Governments of the member countries. In status it is
like IMF and BRD, but like them is not an organ of the UN.
 The Agreements of the WTO are permanent and binding on all members. Action can be
taken against the defaulting members.
 The WTO system of settlement of disputes is automatic, quick, and mandatory for all
members in dispute, whereas the GATT system was dilatory and not binding on the

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 parties in dispute. The WTO is a rule-based organization where decisions on Agreements
are time bound. The extension of the date line could be done consensus. But the GATT
was only a forum for free expression of views. A negotiation round could take even a
decade or more in completion.
 The scope of WTO is wider than the GATT. The GATT rules covered only trade in
goods (trade in services was included in the Uruguay but no agreement could be
reached). On the other hand, WTO covers trade in services, intellectual property rights.
 The organizational set up of WTO is much bigger than GATT.

The WTO Agreement

It consists of the following:

 The multilateral Agreements on Trade in Goods

 General Agreement on Trade in Services
 Agreement on Trade -Related Aspects of Intellectual property rights (TRIPS)
 Understanding on Rules and Procedures governing the Settlement of Disputes
 Plurilateral Trade Agreements
 Trade Policy Review Mechanism
5.2. Issues of Globalization

Globalization- many interpretations

Core economic meaning: - the increased openness of economies to international trade, financial
flows and foreign direct investment. Concerns with global many developing countries rely
heavily on exports of primary products with attendant risks and uncertainty. Many developing
countries also rely heavily on imports (typically of machinery, capital goods, intermediate
producer goods, and consumer products). Many developing countries have chronic deficits on
current and capital accounts which deplete their reserves, cause currency instability, and may
slow economic growth.

Today’s globalization brings many benefits and advantages but also has some disadvantages or
harmful side effects. In fact, there is a great deal of disagreement as to the extent and type of
advantages and disadvantages. Does getting cheaper and/or better products and service from

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abroad justify sacrificing domestic jobs? Why some people in some countries are very rich and
obese while others dismally poor and starving?

Although labor migration generally leads to the more efficient utilization of labor, it also leads to
job losses and lower wages for less-skilled labor in advanced nations and harms (i.e., it is a
“brain drain” for) the nations of emigration. Similarly, financial globalization and unrestricted
capital flows lead to the more efficient use of capital throughout the world, as well as provide
opportunities for higher returns and risk diversification for individuals and corporations. But they
also seem to lead to periodic international financial crises, such as the ones that started in Asia in
1997 and affected most other developing countries, and the subprime housing mortgage crisis
that started in the United States in 2007 and affected the entire world in 2008 and 2009. Finally,
are we running out of resources such as petroleum, other minerals, water? Is the world headed
for a climate disaster?

These disadvantages and negative aspects of globalization have given rise to a rethinking of the
age-old belief in free trade and to a strong ant globalization movement, which blames
globalization for many human and environmental problems throughout the world, and for
sacrificing human and environmental well-being to the corporate profits of multinationals.

Globalization is being blamed for world poverty and child labor in poor countries, job losses and
lower wages in rich countries, as well as environmental pollution and climate change throughout
the world. Although there is some truth in these accusations, an in-depth economic analysis will
show that often the primary cause of many of the serious problems facing the world today lies
elsewhere

Globalization is important because it increases efficiency in the production of material things; it

is inevitable because we cannot hide or run away from it. But we would like globalization also to
be sustainable and humanizing and, ultimately, “fair.” This requires a profound change in world
governance. Such is the challenge facing humanity today and in this decade. All these topics and
many more are either directly or indirectly the subject matter of international economics.

5.3. Regional Economic Cooperation and Integration

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Economic integration refers the commercial policy of discriminately reducing or eliminating
barriers to trade between select groups of countries.

There are different forms of economic integrations:

1. Preferential trade arrangements: it provides lower barriers to trade among participating

nations than on trade with non-participating nations and is the loosest form of economic
integration.

2. Free trade areas: it is one form of economic integration that removes all barriers to trade
among members, but each nation retains its own barriers on trade with nonmembers.

The North American Free Trade Agreement (NAFTA) is a free trade area. The main objective
NAFTA ; for instance, includes: eliminating barriers to trade between the United States of
America, Mexico, and Canada, improving intellectual property rights protections between the
member nations, providing a dispute resolution mechanism for trade disputes under this
agreement, the proposed Free Trade Area of the Americas (FTAA) if broadly modeled on the
NAFTA, The FTAA is designed to generate a free trade area throughout the western hemisphere
(excluding Cuba)

3. Customs union: it is a form economic integration that removes all barriers to trade among
members and harmonizes trade policies toward the rest of the world

4. Common market: it is a form of economic integration that removes all barriers to trade
among members, harmonizes trade policies toward the rest of the world, and allows free
movement of labor and capital among member nations.

The European Union (EU) is an example of a common market.

5. Economic union: it is strong from of economic integration that removes all barriers to trade
among members, harmonizes trade policies towards the rest of the world, allows free movement
of labor and capital among member nations, and unifies monetary, fiscal, and tax policies of
members.

In sum, the following are the main steps towards economic unification:

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  Removing internal tariffs and duties;
 removing impediments to free movement of labor and capital;
 harmonizing corporate law practices;
 harmonizing environmental regulations; and harmonizing labor standards

Effects of regional trade agreements

 Static effects

Trade creation effect (consumption effect, production effect)

Trade diversion effect

 Dynamic effects

Economies of scale

Greater competition

Investment stimulus

5.4. Summary and conclusion

 The GATT was progressively expanded, and became the most important multilateral
trade institution in the world up to the mid 1990’s. Between 1947 and 1994, the GATT
promoted 8 rounds of multilateral trade negotiations.
 The WTO came into existence on the conclusion of the Uruguay Round of GATT on 15
April 1994. It succeeded the GATT which was a forum where the member countries
discussed and found out solutions to the problems confronting the world trade. The last
and most important GATT agreement took place between 1986 and 1994 and involved
123 countries; it came to be known as the “Uruguay round”
 The scope of WTO is wider than the GATT. The GATT rules covered only trade in
goods (trade in services was included in the Uruguay but no agreement could be
reached). On the other hand, WTO covers trade in services, intellectual property rights.

79
 Today’s globalization brings many benefits and advantages but also has some
disadvantages or harmful side effects.
 Economic integration refers the commercial policy of discriminately reducing or
eliminating barriers to trade between select groups of countries.

80